But many fund managers appear to hold certain assets even when it would be prudent to walk away, going against their more rational judgement and demonstrating a very human susceptibility to behavioural biases.

 

The impact of behavioural biases can be so strong on investors and their investment decisions that Israel prohibited the display of retirement funds' investment returns for periods shorter than one year; in doing so, they limited the impact of short-term, recent performance on investment decisions.

 

This approach may minimise the impact of a few biases, but drawing lessons from behavioural psychology and economics, we can identify a broad range of investment biases. There are three in particular that may incentivise investors to cling to stocks a little too tightly.

 

The endowment effect, or why investors love the stocks they hold

 

If you offer someone a gift - say a free mug or a fascinating book about behavioural economics - and ask them to value it, they will generally put a higher price on it than someone who does not hold it. This is called the endowment effect. It is one of the reasons, alongside transaction costs, that people tend not to decide to sell all their investments, start with a blank piece of paper and begin afresh.

 

For example, long-term investors in construction companies may have had a difficult time adjusting to recent share prices, though they also need to consider whether selling is cementing their existing losses.

 

Status quo bias, or why people will do anything for a quiet life

 

It is within everyone's power to do nothing, and we prefer not to change. This basically works on the premise that not making an alternative decision is less painful than choosing a new option. Investors start from a position from which they view anything they lose by selling a share as a loss and any gains from moving on as a gain. Because people tend to attach more significance to losses than to gains, investors are less likely to sell past losers - hence the status quo bias.

 

Confirmation bias, or why investors love some stocks despite their faults

 

Once people make a decision, they don't like changing it. We tend to believe we are right and have overconfidence in our choices. As a result, new and useful information that doesn't agree with our current thesis will often be discounted, while less useful information may be used to confirm existing views. Investors do this all the time. Once they have received new information that doesn't confirm their thesis, they may fail to process it properly.

 

These are only three out of a wide range of behavioural biases that can influence and in some cases undermine investment decisions.  Increasingly, investment professionals are using this knowledge to design better investment solutions and even gain an advantage over the rest of the market. At the very least, identifying biases may help to know what investors - and indeed, we as fund managers - may be thinking.