Overcoming personal bias in investment decisions

Professor Madan Pillutla explains how to improve good judgement in making financial choices and the importance of removing bias from investment decisions

We are all prone to bias when making decisions, but understanding what influences this bias will help us use tactics to help overcome such influences. A basic understanding of the research on debiasing is therefore important for both the financial services industry and for individuals

A key first step to managing bias is an awareness of the impact of personal experience on preferences.

“While experience comes in very handy when making essential or even life-threatening quick decisions, a more considered choice is wise – if not a pre-requisite - of successful long-term investment and financial matters.

“As a result, understanding how personal bias and experience can influence decisions is fundamental for both the financial services sector and individuals,” says Madan Pillutla, Professor of Organisational Behaviour at London Business School.

Below, Professor Pillutla highlights four approaches to help remove bias from decisions:

1. Incentives and accountability can be useful where more effort is required. While incentives can have some success, research shows that incentivising or rewarding ‘good’ decisions is far from being a perfect solution. Unless the key problem causing poor decisions is a lack of effort, providing incentives does little to facilitate better decisions compared to situations where no incentives are offered. Similarly, holding people accountable for their decisions does not appear to improve matters.

2. Training and education are helpful, but have limited value beyond simple decisions. By understanding how bias operates, you have a better chance of managing your reactions. Training for specific situations, including professional environments, can be very useful in minimising simple mistakes in vital decision making.

3. Frugal heuristics or ecological rationality can help with complex decisions. Essentially, this means explaining information clearly and with as many specifics as possible. For consumers, it means asking for such clarification before making a decision. As an example, research shows that expressing the likelihood of an event happening as a chance of, say, five in 10 thousand means people grasp the implications more readily than hearing that the probability is 0.05%. Professor Pillutla believes this is an area ripe for future research.

4. Nudge or choice architecture to guide people towards a suitable choice. This is increasingly used by policy makers to encourage people towards the ‘right’ decision. For example, by guiding individuals to opt into a stakeholder pension or choose a default option investment strategy. There are issues of trust here, for instance, how can one be sure that the interests of the policy maker designing the nudges is aligned with the common interest?

(Please see Larrick, R. P. (2004). 'Debiasing'. Blackwell handbook of judgment and decision making, 316-338, for a detailed review of the literature).

Read an interview with Professor Pillutla in International Pensions Europe and hear his full presentation at the latest AQR Asset Management Institute Summit.