Human Biases and Decision-Making: Why Portfolio Managers Might Hold Onto Loss-Making Trades

Aug 30 / Geoff Robinson



Another good question arose over another evening spent in a beverage servicing establishment in the City. It's a question that has been well-researched over the years, but still, the phenomena reoccur.
Financial markets are often described as rational and efficient, but the people operating within them are human. This means they're subject to many cognitive biases that can impact their investment decisions.

In this blog post, we explore why due to human biases, portfolio managers might hold onto loss-making trades longer than they should and why they might not take action quickly enough.
The Psychology of Losses
When a trade turns against us, the most rational action seems clear: cut the loss and move on. However, human psychology often intervenes, making this decision much harder. This phenomenon can be explained through two primary psychological biases: loss aversion and the disposition effect.

Loss Aversion: Coined by psychologists Daniel Kahneman and Amos Tversky, loss aversion is the tendency for people to prefer avoiding losses to acquiring equivalent gains. In the context of portfolio management, this bias can cause a manager to hold onto a loss-making trade in the hope that it will rebound rather than accept the loss.

Disposition Effect: This bias refers to the tendency of investors to sell assets that have increased in value while keeping assets that have dropped in value - again, in the hope that these losses will be recovered.

As noted by Kahneman, who won a Nobel Prize for his work in behavioral economics, "Losses loom larger than gains." This succinctly captures the psychological struggle that portfolio managers face when dealing with loss-making trades.

Why Action Might Not Be Taken Quickly Enough
Several cognitive biases can contribute to inaction or delayed action in the face of deteriorating trades:

Confirmation Bias: This tendency favors information confirming our preexisting beliefs while ignoring information contradicting them. If a portfolio manager is firmly convinced about trade, they might dismiss negative news as temporary noise, delaying a much-needed decision to cut losses.

Anchoring: Anchoring occurs when an individual overly relies on an initial piece of information (the "anchor") to make subsequent judgments. A portfolio manager may anchor to the price they paid for a stock, making it difficult to sell it at a lower price.

Overconfidence: Some portfolio managers may have an inflated belief in their ability to predict market movements. Overconfidence can cause a delay in recognizing a losing position, as the portfolio manager may believe they're right and the market is wrong.

Renowned investor Warren Buffet has famously said, "The first rule of investment is don't lose money, and the second rule is don't forget the first rule." These words highlight the need for swift action when a trade turns sour, but cognitive biases can sometimes make it challenging to implement this advice.

Conclusion

Despite the advanced analytical tools, portfolio managers are prone to cognitive biases that can cloud judgment and impede decision-making. Recognizing these biases is the first step toward mitigating their impact. By blending the art of understanding human psychology with the science of finance, portfolio managers can better navigate the complexities of the market, manage risk more effectively, and, ultimately, enhance the performance of their portfolios.