Brandes Quarterly Letter: Guarding Against Natural, Built-In Biases
Our thought leadership division, the Brandes Institute, routinely writes about biases that can derail even the best investment strategy. Cognitive biases such as anchoring, confirmation and survivorship are natural, built-in biases that can cause real damage if not identified and guarded against.
We recommend establishing rules and guidelines to help investors manage innate biases. One effective resource we developed with behavioral finance expert Dr. Frank Murtha* is the “Investor Stress Management Plan.” This tool is designed for use by individual investors and plan participants. The idea is for them to describe in their own words the actions they will take, for example, during a market correction. By identifying logical responses before a stressful event happens, investors may feel a greater sense of control when one actually occurs—because they “knew” it would happen and how to respond.
On the theme of behavioral biases, two items caught our attention over the past few months. The first, which on the surface is unrelated to investing, provides a history lesson on how the U.S. armed forces sought to protect combat planes during WWII.1 The second item, which is more directly related to investing, pertains to the largest cohort of professionals in our industry: 25 to 34 year olds. This group has never experienced a period in which value stocks outperformed their growth counterparts.
Why do we think these seemingly unrelated items offer important insights for today’s investment professionals in spotting and dealing with behavioral biases?
In an effort to help reduce damage from enemy fire, the U.S. military decided to armor its bombers and set out to determine the most efficient way to do it. They rigorously analyzed what they thought was all available data and produced a diagram indicating where the planes were sustaining the greatest damage. The theory was straightforward: Reinforce the areas with the most red dots (see corresponding image). However, the engineers succumbed to what has come to be known as survivorship bias.2 This is the tendency to focus on the available data and ignore failures which may have reduced the size of the sample. The engineers failed to recognize the obvious—the areas on the planes that sustained no damage were actually the most vulnerable. Why is that?