Cognitive Biases in Investing: Incentive-Caused Bias

What is incentive-caused bias?

Incentive-caused bias is the power that rewards and incentives can have on human behaviour, often leading people to engage in inequitable behaviour.

Incentive-Caused Bias explains why people with a vested interest in something will tend to guide you in the direction of their interest.

Where does bias occur a) in life and b) in finance?

In life:

If you’re looking to sell your house and you ask a real estate agent to come and value the property, they are initially likely to overprice the house, irrespective of market conditions, as they work for commission. Meanwhile, the bank who are providing the mortgage will tend to make a comparatively safe valuation, given they could stand to lose money if the house is overpriced.

In other words; don’t ask the barber if you need a haircut.

In Finance:

An example in finance: A supervisory board of a company promised management a bonus if targets were met. What happened? The managers spent more energy on agreeing on the lowest possible targets instead of on managing profitably.

An alternative example: A participation in the profit (= incentive) tempts many investment managers / traders to take high risks.

Conclusion:

Paying lawyers, architects, consultants, accountants or driving instructors by the hour is unwise. These people have an incentive to generate as much time and effort as possible. Therefore, agree on a fixed price in advance.

In the words of Charlie Munger, Vice-Chairman of Berkshire Hathaway, and a proponent of incentive-caused bias; “Show me the incentive and I will show you the outcome.”

How does VARUNA avoid the bias?

Investment managers of hedge funds receive a share of the profits. A high return also leads to a high profit sharing. The incentive is thus also to take high risks.

The cornerstones of our portfolio management are:

a) Prediction of asset returns from a large pool of investment possibilities

b) Risk management

c) Portfolio optimization

VARUNA avoids incentive caused bias through fully automated, systematic and rigorous risk management. Each individual strategy is given a daily risk budget based on volatility, correlation, etc. The higher the volatility (= risk), the lower the allocated assets. Each individual security of a single strategy has a position limit combined with an initial stop loss. The portfolio construction is also long/short.

The result is a very large number of transactions per day with a very low individual risk.