diverseo gone with emotions could biases blow your financial institution

8/11/2019 Diverseo Gone With Emotions Could Biases Blow Your Financial Institution

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Cognitive bias advisors

Gone with emotions:Could biases blow your

financial institution?


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The human mindsrapid response is un-conscious. What iscommonly referred to

as thinking is onlypart of the story

A significant proportionof decisions are irrational.This is due to the way themind works, and how itgenerates biases

Traditional approachesfail to address cognitivebiases

Recent scientific pro-gress enables practical,innovative and effectiveapproaches to addres-sing biases

Investors, supported as they are by complex financial models, multiple sources of informationand highly sophisticated control systems, tend to believe their decisions are rational. Whenin doubt, they seek comfort in the collective wisdom consecrated by the efficient-market hy-

pothesis. It is often said, however, that decision-making is more of an art than a science. Andit seems that science agrees that decisions are sometimes made outside of our own control:over the past three decades, many eminent researchers in mind sciences, including NobelPrize winner Daniel Kahneman, have shown that emotions, addictions and cognitive biases

(which are bugs in the way the brain operates) influence investors and traders, as they doall human beings. These factors affect not only their individual decisions but also the pro-cesses that their organizations design and implement. Accordingly, addressing the impact ofthese cognitive biases should be a high priority for financial institutions as it will allow themto significantly increase performance.

Recognizing biases is difficult; typically, they are ascribed to control failures or humanerrors. Organizations invest vast sums in addressing bias using traditional approaches: com-

plex algorithms along with more constraints, controls and regulations. This is increasinglycostly and only goes so far. However, these traditional approaches largely fail to address theirrationality of decision-making that derives from the unconscious mind, which is beyond

every individuals self-awareness. This is because they focus on creating external constraintson individuals, but do not address their unconscious internal preferences.

Achieving shifts in mindset and the transformation of decision-making processes is thusboth crucial, but also more difficult to do. Applying recent progress in cognitive sciences tofinancial decision-making makes it possible to develop new approaches to such issues, andto be more effective in instigating behavioral change.By combining a mix of very practical tests to assess individuals biases with a redesign ofsome decision-making processes, financial institutions can achieve impact. Heres how.

Understanding the implicit mechanismsbehind decision-making processes

Under certain conditions, investors systematically make wrong decisions. This is due

to bugs in the way the brain processes information

Whether it belongs to a star trader or a chemistry student, the human mind operates verymuch like a computer with two processors: an unconscious processor System 1 and aconscious processor System 2. Whenever we have to make a decision, System 1 acts first:

it is the rapid-response tool, capable of processing large amounts of information very qui-ckly, before we are even consciously aware that we are processing it. Then, a fraction of thatinformation is passed on to System 2, by means of a complex and so far little understoodmechanism. We then begin to think deliberately, controlling the content of our thoughts.

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The conscious mind isnot very good at under-standing and correcting

the bias introducedby the unconsciousmind

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FRAME B

REASONING COGNITIVE BIAS: SYMPTOMS AND IMPACTS

Reasoning cognitive bias arises when System 1 uses short-cuts in the reasoning process and System

2 does not override them effectively. This bias can be reinforced by stress or attention focused on other

matters. Here are some examples of reasoning bias and how it can reduce organizational performance.

Finally, three key elements should be kept in mind. First, biases become entrenched overtime. For instance, occasional risk-seeking behaviors easily evolve into frequent risk-seeking

behaviors. Once a pattern of risk-taking decisions becomes ingrained, there is little room leftfor further unconscious deliberation. In some extreme, and sadly common, cases, this behaviorcan degenerate into a pathological risk addiction. Secondly, some work environments canreinforce biases while others more effectively allow decision-makers to reduce their impact.Thirdly, biases can be allowed for. Once unconscious biases are surfaced (i.e. when people

become aware of them), people can act on them and reduce their impact.

FRAME C

BEHAVIORAL COGNITIVE BIAS: SYMPTOMS AND IMPACTS

Behavioral bias arises from experiences and can be reinforced by some emotional states. Here are

some symptoms to watch for, and the impact behavioral cognitive biases may have on teams.

Biases are universaland self-reinforcing, butthe right environmentcan reduce them, andonce surfaced, they canbe tackled

Types of bias Description Symptoms Impact

Hindsight bias Seeing past eventsas predictable I knew it all along! Underestimatesuncertainty of forecasts

Disposition effectHesitating to sell

losers and rushingto sell winners

I have too much on thisposition... I have to holdit at least until it comesback to its initial price.

Misses investmentopportunities and

suffers heavier losses

Probability neglect

Thinking that eventsare less likely to occur

if they have neveroccurred before past

Government bondscannot default.

Miscalibrates probabilities

Authority biasOverestimating the

validity of the opinions ofrecognized authorities

What you are doing isnonsense... This report

says to do the opposite.

Gathers data from fewersources and seeksfewer viewpoints

Types of bias Description Symptoms Impact

Riskseeking

Making risky decisions toget a sensation of pleasure

Oh man! Im so thrilledright now...look at those

numbers go!

Over-exposesportfolios without

adequate justifcation

Overconfidence

Overestimating theaccuracy of information

I know these numbers areodd... but trust me, I have agood feeling about this.

Neglects models or data andmiscalibrates probabilities

Herd effectImitating the behavior

of othersCmon, this is the next big

thing, everybody is going in!

Over-evaluates fadsand uses inconsistentinvestment strategies

Overoptimism

Believing that negative eventsare less likely to occur to

oneself than to others

Yesterday the marketwas really rough but today

Im feeling its gonnabe a smooth ride.

Underestimatesuncertainty of forecasts

Equity homebias

Holding larger amount ofdomestic equity relatively

to foreign equity

Their headquarters is rightnext door. I know people

there, theyre solid.

Misses investmentopportunities

Managerialhubris

Tending to think one canmanage frms better than

other managers can

This firm is fallingbehind because of bad

management. We can dobetter with their assets.

Overestimates fnancialimpact of an acquisition

Sunk-costheuristic

Focusing on investmentsin which costs havealready been paid

We already invested toomuch in this company,we shouldnt let it go!

Tends to misallocateresources and to suffer

from cost overruns6



Addressing biases to better enhanceperformanceBy addressing cognitive bias, financial institutions can achieve a profound, lastingtransformation in mindsets and business models

Most companies, whether financial institutions or industrial firms, often feel ineffectivewhen attempting to tackle such issues. Cognitive science provides new and effective solutionsto address these undesirable negative effects, offering companies an untapped opportunity tokeep one step ahead.

The impact of cognitive biases on financial decisions has many aspects, affecting, forinstance, attitudes towards novelty, time or risk (See Frame D).

Countering the deceptive nature of cognitive biases increases profitability, improves riskmanagement and enhances reputation (see Case Study).

Addressing cognitivebias is a significantperformance driver

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FRAME D

CAPTURING AND ADDRESSING THE BEHAVIORAL SIDE OF RISKMeasuring unconscious attitudes towards risk to enhance performance

Most individuals display irrational behavior when facing risk. Many of us are risk-aversewith regard to gains and risk-seeking with regard to losses. These behaviors can bedramatically influenced by national culture, work environment, neurobiological factors

and, of course, personal past experiences.

There is no right attitude towards risk. Nevertheless, some attitudes are more appropriateto a particular task, function or business outlook. Serial entrepreneurs tend to be comfortablewith a degree of risk, while managers of on-going business tend to be risk-averse. Suchindividual attitudes to risk are rarely affected by decision-making processes and metrics,and are quite difficult to change with traditional tools. Research has shown that personalitytraits, such as sensation seeking, alter individuals risk-taking behavior by altering theirrisk tolerance. However, while research shows that the perception of risk depends on thecontext crossing the street, skydiving any individuals preference for risks is stableacross contexts. Accordingly, measuring risk preferences enables risk-taking behavior to be

predicted in any context, including financial decision-making. The ability to capture theseindividual attitudes can then become a powerful performance lever for financial institutions.

Risk-taking behaviors are influenced by a tangle of cognitive biasesIn the light of D. Kahnemans well-known Prospect Theory, three main factors involvedin risk-taking behaviors have been studied over the past three decades: Risk perception, which relates to how individuals implicitly evaluate the probability of an event. Risk preference, which relates to the preference for a risky, uncertain payment over a certain payment. Loss aversion, which relates to the aversion for negative outcomes.

Numerous cognitive biases can inf luence these three parameters. Most of them areunconscious and are generated by our System 1 thinking. They result from our immediateenvironment, our corporate culture and our individual past experiences. Some of themare influenced by our environment (herding effect). Others, such as overconfidence, self-esteem or overoptimism, have a stable impact.

The challenge: surfacing and measuring the cognitive biases involved in risk-takingbehaviors so as to instigate behavioral change and best manage risk positions

People are rarely aware of their actual risk attitudes and their impact on their decisions. Ifyou are asked to evaluate the strength of your risk-aversion on a 10-point scale, you will

face many problems in interpreting the result. First, you may unconsciously adapt youranswer to what is expected from you in terms of function and sector. Second, you may beunable to evaluate your own risk-aversion introspectively. Third, you may be influenced byother biases, such as your preference for extreme or medium ratings just as in other typesof self-assessment.

The best way to address these issues is to use highly sophisticated yet practical tests whichdirectly target our unconscious way of thinking System 1 so as to surface cognitive

biases we are not even aware of.

That is why we have developed the Risk CogPIT, which is based on the latest advances in

mind sciences. Its results generate awareness of biases and help in predicting the risk-takingbehavior of individuals in real-life financial decisions. Being aware of ones own result isthe first step to change. For instance, being aware of a tendency to be overly optimisticcan help in taking a step back and double-checking whether decisions or trading volumesare appropriate, or whether it is time to adopt a low-risk strategy instead of a high-risk one.

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Three practical levers to reduce biasCreating a bias reduction plan (specifically, identifying, measuring and reducing biases andtheir impacts) allows organizations to gain competitive advantage. It generally consists of:

Surfacing biases and measuring their strength and impact with a mix of interviews andDiverseos CogPit, featuring advanced tools derived from mind sciences. The CogPit

enables unconscious biases to be surfaced and measured. A quantitative measurement of theimpact of the biases generally fosters willingness to change.

Analyze decision-making processes through a bias lens in order to assess how processescan be tailored to reduce the impact of biases. Our experience and the latest research inmind sciences show that some decision-making processes are ineffective in reducing theimpact of biases. Some may even reinforce biases. In our experience, small, invisible cuescan sometimes have a significant impact on decisions made.

The cognitive bias reduction plan generally includes three core pillars:

1. A shift in mindset with the Cog PIT

As mentioned above, biases can be malleable once they have been surfaced. Thus, to achievethe required profound change in corporate culture, the first step is for organizations toidentify these biases and generate awareness of biases in as many employees as necessary,using the Cog Pit and cognitive teasers, practical exercises to identify specific reasoning

biases. They can then begin to instill a sense of individual responsibility: a crucial stepin achieving progress. This can also help individuals to make better decisions on when toadopt a higher-risk strategy or a lower-risk strategy, depending on the market and their owncognitive profiles. Well-designed corporate communication and awareness sessions can

bring about behavioral change both individually and collectively.

2. A more granular assessment of the impact of corporate culture on cognitive biases

The Cognitive Profile Dashboard (see Frame E) has a place in the managers toolkit forperformance management. Gathering information on various biases, it can help:

Assess the culture by producing a global picture at a specific point in time.

Enhance risk control by adapting controls better to specific individual risk preferences see the Risk Cog Pit.

Shape teams better, providing an unparalleled chance for managers to recruit and match investors or traders to specific markets, products or clients, taking into account their

implicit preferences and behaviors.

The Cognitive ProfileDashboard can help:- assess the culture- enhance risk control

Cognitive profile testsand cognitive teasersare effective tools tosurface and addressbiases

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FRAME E1

THE INDIVIDUAL COGNITIVE PROFILE DASHBOARD

Individual attitudes and preferences make it possible to define an individuals risk-relatedcognitive profile. The Cognitive Profile Dashboard combines the different financial cognitive

profiles of teams of professionals, enabling managers to easily monitor and compare the strengthof biases and assess the impact of their work environment.

Example of a Cognitive Dashboard regarding risk-taking behaviors:

Using a bias-strength scale, managers can readily:

Best match team members with risk perceptions and preferences to specific positions.

Target or prioritize specific controls on individuals in particular market circumstances.

Develop adapted training sessions.

FRAME E2

THE TEAM COGNITIVE PROFILE DASHBOARDExample of a Cognitive Dashboard regarding risk-taking preferences and perceptionsof a team of 20.

Using a bias-strength scale, managers can readily:

Best shape teams, with accurate cognitive profiles regarding their objectives.

Implement, and monitor the impact of, actions geared to a shift in mindset.

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3. More objective decision-making processes

As mentioned, cognitive biases are often embedded in decision-making processes, whichthus do not effectively allow decision-makers to reduce the impact of their biases.

The results of the diagnostic enable the redesign of the decision-making process to be tailoredto the issues identified. In many instances, the specific actions are simple and pragmatic. Inour experience, some simple mechanisms are often effective, such as:

A more structured process to ensure better sharing of relevant information across several

decision-makers, such as weekly meetings to challenge assumptions. One bank systematically provided derivative traders with on-going information from fixed-income traders; it fared better than its competitors through the Greek crisis.

Providing decision-makers with additional, simple information, such as pre- and post- decision assumptions. For example, overconfident traders often tend to underestimate market volatility and fail to hedge themselves adequately. Providing them each week with the previous weeks assumptions helps them better define how to hedge their positions.

Other more complex issues might require complex, costly solutions such as a complete redesign of information f low, decision-making criteria and supporting IT systems. In some instances, we have observed that algorithms using past data can effectively

complement more ad-hoc decision-making processes. However, adding additional algorithms should only be considered after exhausting the ample possibilities afforded by simple, straightforward levers.

Tailored redesign ofdecision-making pro-cesses based on ananalysis using a biaslens

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CASE STUDY:

THE OVERCONFIDENT TRADER

Traders use sophisticated mathematical models and heuristics to make financial decisions.They are also fairly free to make decisions during day-trading, and thus rely frequently on

personal best practice, insights and intuition.

Traders who suffer from unconscious overconfidence trade unusually high volumes andhave less diversified portfolios. This behavior stems from their belief that the informationthey have is more accurate than it really is in some cases, they even believe in the accuracyof information that they do not actually possess. Diverseos set of proprietary tools can helpcounter the harmful effect of unconscious overconfidence on the trading floor.

As a result, managers are able to:

Manage trading teams better, by taking into account implicit behaviors and preferences. This could include assigning traders who are relatively more overconfident to less volatile markets or products, so as to reduce the impact of a high trading volume when limiting risk is complex but necessary.

Adapt control procedures better to areas where bias has the greatest impact. By detecting those trading areas in which overconfident traders operate, risk managers could increase frequency or prioritize their periodic controls.

Further increase the profitability and reliability of operations, by focusing attention

on specific issues that hinder performance. By establishing an appropriate trading volume benchmark using data from relatively unbiased traders, teams can adjust their trading behavior objectively whenever needed.

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Combining techniques derived from state-of-the-art research in mind

sciences and technical expertise in f inancial activities, financial

institutions can now achieve a profound and lasting shift in mindset. The

practical use of cognitive sciences in finance is a key ingredient of the

finance of tomorrow. The first organizations to seize this opportunity

pragmatically will enjoy a decisive competitive edge.

As the preeminent consultancy specialized in cognitive bias reduction,and with proven financial expertise, Diverseo can assist your institution

in better leveraging cognitive sciences to reduce the impact of biases in

decision-making and enhance performance. Your Diverseo advisor can

help you construct the cognitive bias reduction plan that will best fit

your needs.

For more information: [email protected]

Diverseo is the preeminent cognitive-bias advisor.

Diverseo develops highly innovative approaches to improve the quality ofdecision-making and change behaviors effectively. On founding, the f irmimmediately became the exclusive business partner of Project ImplicitTM,an international research enterprise created by eminent researchers suchas Dr. Mahzarin Banaji, Harvard University.

Nathalie Maligeis the CEO of Diverseo. She advises CEOs in leading the transformationof their organizations to improve the quality of decision-making. Prior to foundingDiverseo, she held international roles in general management consulting andmarketing at P&G, Diageo and McKinsey. She is a graduate of ESCP-EAP.

Martin Schoelleris the COO of Diverseo. He leads client projects and develops newbusiness approaches derived from cognitive science. Martin joined Diverseo fromMcKinsey, and has started his career as a project leader at RFF. Martin is a graduateof Ecole Polytechnique, Ecole des Ponts Paris Tech, and holds an MBA from Insead.

Fatine Jabreis a consulting project leader at Diverseo, where she leads projects

in the financial industry. She started her career in the banking industry in M&Aand then joined Socit Gnrale as an inspector, working directly for themanagement board. She is a graduate of EDHEC.

Tiphaine Saltin iis an expert in cognitive science and a consultant at Diverseo.She graduated from HEC Paris and ENS Ulm in cognitive science, and wasa visiting scholar at Harvard University prior to working as a consultant forAccenture and Vivendi.

SOURCES

Kahneman,Attention and Effort, 1973.

Bardolet, Corporate capital allocation: a behavioral perspective, Strategic Management Journal, 2011.

Odean, The Courage of Misguided Convictions: The Trading Behavior of Individual Investors, Financial Analysts Journal, 1999.

Biais, Judgemental overconfidence, self-monitoring, and trading performance in an experimental financial market,The Review of Economic Studies, 2005.

Fox, Tannenbaum, The elusive search for stable risk preferences. Frontiers in psychology, 2011

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diverseo gone with emotions could biases blow your financial institution

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