Veritas: What fund managers can teach Euro leaders about decision making

Lee Freeman-Shor, Portfolio Manager of the Skandia Best Ideas Funds, identifies a sinister, hidden force at work that is undermining any immediate solution to the European crisis.

The Eurozone’s problem is well known: when creating the Eurozone, the chef forgot to add that important ingredient known as ‘fiscal union’. And the solution – fiscal transfers from the wealthy Eurozone members, particularly Germany, to the poorer Southern European countries – is also apparent.

So why is a comprehensive solution not forthcoming? Clearly the visible force is German Chancellor Angela Merkel, but the hidden force is ‘sunken cost bias’. Sunken cost bias is a devastatingly powerful behavioural trait and one, in my view, which is causing much of the paralysis European policymakers currently demonstrate.

Quite simply, this bias conspires to make European leaders unable to make objective decisions when they are losing the battle, and it ultimately results in the person under its influence doing nothing.

Interestingly, this bias is also found in the most unsuccessful investment managers. Andrea Frazzini, Adjunct Associate Professor of Finance at Leonard N. Stern School of Business, wrote a prize winning research paper entitled “The Disposition effect and the under-reaction to news”. It appeared in the Journal of Finance in August 2006 and examined all the mutual funds registered in the United States plus an additional 3,000 globally, during a period from 1993 to 2002.

Prof Frazzini found that the best performing fund managers realised the highest proportion of losing trades. In other words, when they were losing, they sold. On the flipside the managers with the worst performance track record realised the least amount of losing trades. When they were losing, they did nothing (except, I suspect, to pray for God’s intervention to get them out of the hole they had dug). They were too scared to do anything, for fear of making the matter worse.

So how does sunken cost bias work? Let’s take the example of a house purchase. Imagine you bought a house in 2007 for €500,000. Now in 2012, five years after your initial purchase, you decide you want to sell and I make you an offer of €350,000. Would you sell? 

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