Applying lessons from behavioural finance to inclusion and diversity

Tuesday 8 September 2020

Inclusion and diversity

Author: Matt Jones, CFA

Humans aren’t rational

Hopefully this isn’t news to anyone! Over millennia we’ve developed mental shortcuts to help us process the deluge of information that we’re faced with every day.  These heuristics lead to blindspots and unconscious biases, which can be seen in the market, but also in the way that we construct and operate within teams. 

Along with pattern recognition such heuristics are examples of what Kahneman and Tversky term ‘system one’, contrasting it with the careful analysis of evidence of ‘system two’. 

What this can mean for diversity

Taking the example of an interview this means superfluous information can bias your assessment of whether to hire a candidate onto your team.  Maybe you look favourably on them as they attended the same university or you rule them out immediately on account of their weak handshake; both of these cases are examples of heuristics prevailing over careful consideration.

By studying the impact of blind auditions we can observe the impact of such biases.  Removing identifying information has been found to result in women’s open-source code amendments being more likely to be approved than men’s, women-led projects becoming more likely to be granted use of the Hubble Space Telescope than those led by males and an increase in the proportion of graduate hires from state schools.

The ‘diversity dividend’

At the same time diversity is a quality that all teams should aim for; it helps to combat groupthink and leads to better processing of information and thus more effective decisions.  According to a recent McKinsey study companies in the top quartile on gender diversity are 21% more likely to have above average profitability than companies in the fourth quartile; this rose to 33% when looking at ethnic and cultural diversity.

Diversity is particularly potent as we try to make sense of the disruption wrought by the Covid-19 pandemic; in its wake businesses may need to reimagine their operating models or products and therefore the need for new ideas and fresh perspectives has never been greater.

How do we manage these biases?

Knowledge of these biases is all well and good but you’re probably wondering what we can do about them.

One powerful way to build more diverse teams is through the use of structured interviews; by making an upfront investment in compiling a comprehensive interview structure one can craft questions designed to reveal whether candidates have the required skills.  The consistency in questions posed facilitates comparison and makes it easier to distinguish between exogenous and endogenous information.

But you can’t just assemble a diverse team and sit back to reap the benefits!  The inclusion part of ‘diversity and inclusion’ can often be an afterthought but it is equally important; the collective intelligence of teams does not happen by magic but rather comes from balanced communication with all contributing and listening with open minds. 

An inclusive team is one where members feel free to share their views.  The team leader is crucial to this, keeping the team on track and actively soliciting the views of all members before giving their own opinion.

What do behavioural biases look like in markets?

As I said at the start of this piece, biases also manifest themselves in the behaviour of market participants.  Perhaps the most extreme examples of this are asset price bubbles, from the Dutch Tulip Mania of the 1630s to the Dot-com bubble of the late 90s, when herding and a lack of diversity of thought causes prices to wildly overshoot.

However, such headline-grabbing events aren’t the only way these biases manifest.  A well-documented anomaly is the momentum effect: that stocks, sectors, currencies and commodities tend to trend over medium-term horizons.  The behavioural explanation for this holds that investors’ overconfidence means they are slow to incorporate new information into their hypotheses while sell-side analysts anchor on their initial forecasts and so do not fully adjust their estimates for new information. 

We do not claim to have conquered these behavioural biases but through blending the structure and breadth of quantitative techniques with the depth of fundamental analysis we do believe we can empower our ’system two’ brains and harvest alpha from exploiting them.



Matt Jones is Vice President at JP Morgan Asset ManagementMatt Jones, CFA, is Vice President at JP Morgan Asset Management. This article is written on behalf of CFA UK’s Inclusion and Diversity Committee.

 

 

 

 

 

 

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