Rethinking risk management: resisting bias in decision-making

When most investors think about risk management, concepts such as volatility or capital loss typically come to mind. These risks are important to consider, but a less obvious source of risk lies within investors themselves. By addressing decision-making processes and the biases that are common to us all, Alesco Advisors can implement investment strategies that help to effectively achieve our clients’ goals.

Intuition vs. Analysis

The processes humans use to make decisions rely on two modes of thinking. Sometimes we use our intuitive mode to make decisions in an instant, relying on instinct in order to guide actions toward achieving a desired goal. In other cases, we slow down and use our analytical mode to deliberately scrutinize potential actions in the context of our objectives to promote an effective outcome. [1] 

Our intuitive mode is helpful in situations when true optimization isn’t necessary because a mere satisfactory outcome might suffice— think about picking an apple from a display at the grocery store. It’s also highly effective in situations where instant decisions are imperative—imagine deciding whether to swerve or brake to avoid an object in the road while driving. It’s proven remarkably useful in the survival of our species, so we all have an evolutionary predisposition to rely on it often. 

Our analytical mode allows us to undertake a process that follows an orderly series of logical steps. It leads to more effective decision-making in cases when it’s both desirable and possible to invest the time, cognitive effort, and attention to promote the best outcome. It’s the kind of thinking that’s best suited to making some of life’s biggest decisions—which career to pursue, what house to buy, and how to structure an investment portfolio to gain the highest probability of achieving your goals.

Implementing a disciplined, data-driven investment process is an important form of risk management for Alesco Advisors. Complex choices regarding investment management are too important to make on behalf of our clients using intuition alone. By interrogating our own thinking and engaging our analytical mode, we ensure the appropriate time, thought, and effort is dedicated to the issues that matter most to achieving investment goals.

Managing Process Risk

Disciplined analysis is a necessary step in managing decision-making risk, but even analytical thinking can be prone to the pitfalls and traps of the human mind. Intuition is impossible to completely “turn off”, so it’s active even when engaging our analytical mode. Our intuitions rely on mental shortcuts, which social scientists call “heuristics”, to simplify decisions. Relying on these heuristics in complex situations can create problems that lead to errors in analysis.

These errors, which social scientists call “biases”, are impossible to completely suppress—after all, we’re only human. But research shows that defending against these biases as they emerge is possible, and begins with an awareness of their existence. Only then can biases be accounted for and addressed.

Some of the more common biases are listed below along with examples of how Alesco effectively manages the risk each presents.

• Recency bias. Humans tend to overemphasize the importance of experiences that are freshest in their memory and allow them to shape unrealistic expectations for the future. For example, the recent extraordinary rise in value of the “Magnificent 7” companies has tempted some investors to load up on these stocks in their portfolios. But past performance does not guarantee future results. While owning these stocks is important, abandoning other worthwhile investments to gain concentrated ownership in these companies adds new risk to a portfolio.
  
  It’s common to have examples of extraordinary companies achieving extraordinary gains in stock price. But a review of market history shows it’s uncommon for those outsized gains to continue. By maintaining discipline to a diversified strategy that is anchored in analysis of investment data, Alesco mitigates this undue risk.
  
  
• Overconfidence bias. Most people, even professional forecasters, are not very good at making predictions. At the same time, humans tend to be overconfident about our accuracy when making judgements. Take for example the overwhelming opinion of economists and market forecasters that a recession was in store for the U.S. economy in 2023. Investors who gave too much credence to projections may have considered abandoning their equity investments—and those investors would have risked missing out on the S&P 500’s 26% return.
  
  The truth is, no one can accurately predict what will happen in the future. Alesco acknowledges the risk in this truth by maintaining discipline to portfolios that hold investments across a variety of asset classes that behave differently, giving clients the highest probability of achieving their long-term investment goals in a variety of market environments.
  
  
• Narrative bias. Sometimes a compelling-sounding story can be more persuasive than actual objective data. The exuberance around the benefit of practical artificial intelligence (A.I.) technology is one such story that investors can easily get caught up in. Consider the following narrative: A.I. stands to revolutionize business; companies that are current leaders in A.I. will benefit more than others; the stock prices of current A.I. leaders will grow more than others; overweight these stocks in your investment portfolio now.
  
  Each of these story lines presents risk. Even if A.I. is as revolutionary as the story says, there is no guarantee that current leaders will benefit more than their competitors. And if they do, the current valuations of these companies make it more difficult for their stock prices to grow faster than others even with the outsized benefits of A.I.
  
  The last point is especially important, because the narrative is already accounted for in the price of these stocks, so investors now need to rely on unexpected benefits that have not been widely considered yet. Alesco factors these risks into its portfolio construction by owning a variety of companies—including current A.I. leaders and others—that could benefit from long-term innovative potential and economic growth.

Alesco’s investment team understands these types of biases pose risks in any complex decision-making process. It's impossible to avoid these biases completely as they are hard-wired in human intuition, which can never be “turned off” in full. But we can commit to following a deliberate process grounded in objectivity in which we engage our analytical mode and call out potential intuitive biases. By doing so, Alesco is able to account for biases, address them, and manage the risk they pose to effective investment decision-making.

[1] These two modes of thinking form the basis of Dual Process Theory, a concept developed over the course of decades by social scientists Daniel Kahneman and Amos Tversky. In his book Thinking, Fast and Slow (2011), Kahneman provides an account of the research, observations, and experiments that led to the development of their theories regarding human decision-making.

The content in this blog post is provided for informational purposes only, and should not be construed as personalized investment advice. The data and information used in the preparation of this blog post are obtained from third-party sources believed to be reliable, but Alesco Advisors does not guarantee the accuracy, completeness, or timeliness of the data and information.