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    Applying lessons from behavioural finance to the Buy vs Build decision

    Posted by Michael Tsangaris on Dec 2, 2021

    Cognitive biases are “flaws” in our thinking, leading us to process and interpret information incorrectly, arrive at the wrong conclusions, and act irrationally.

    Irrational beings

    Homo sapiens are not rational beings. Over time we developed mental shortcuts to build routine into our lives and save mental energy - narrowing down on relevant information. In the information age, this has become more important than ever. However, the heuristics we use often lead to more bias (conscious or unconscious).

    Behavioural finance has been a growing field since it was introduced by the pioneers Kahneman and Tversky in the 1960s. How can we use this field to help explain and combat our own biases when choosing whether to build or buy a monitoring system for shareholding disclosure? 

    Let’s outline some common biases, how they have impacted buying decisions and explore what can be done to question and improve upon them.

    The sunk cost fallacy

    Sunk costs are costs that have already been incurred and that cannot be recovered. People fall prey to the sunk cost fallacy when they continue to invest resources (time, money, effort) into a project because they have already invested resources thus far. This is most easily explained by the phrase “throwing good money after bad”. A simple example is when someone has already purchased a good which they are unlikely to derive much pleasure from (at least the costs outweigh the benefits) however, they will invest further time trying to justify the cost incurred already.

    sunk-cost-fallacy-cartoon

    The most common case we encounter when speaking to prospective clients at FundApps is that they have built a system for monitoring shareholding disclosure, typically using Excel. They are reluctant to look at outsourcing the monitoring portion as they have already paid for legal counsel, developer work and endless VBA macros so they feel as though they need to get their money’s worth.

    Clients must consider that one fine as a result of a missed disclosure far likely outweighs the cost of resources already incurred. 

    We have found cases where prospects were several months into developing an in-house monitoring system before realising they’d be better off outsourcing it. In these instances, the development costs already incurred should be ignored when considering the onboarding of a new system. That is sunk capital that negatively affects decision making. These prior costs also ignore future costs, further development costs, not to mention possible delays and complications.

    In the age of near-instant and broadly disseminated information in the financial markets, there is a strong pull towards short-term thinking. Portfolio turnover has increased from 26% in 1945 to 79% for the average mutual fund between 2005 and 2015. This means that the average holding period has declined from 46 months to 15 months.

    Short-termism can carry over into the world of compliance too. With the pace of regulatory change increasing, with regards to short selling threshold in particular, firms can be tempted to look for the quickest fix to monitor their positions. In an attempt to play catch-up with changing rules, developers within hedge funds resorted to making some shortcuts, or large amounts of manual monitoring to cope with this. Given that not all features can be implemented quickly, poorly written code and compromises in development result in technical debt which must be resolved.

    The feature positive effect

    Short-termism ties in with the feature positive effect - another bias that can hinder decision making, even at an organisational level. This bias leads us to ignore absent information and puts greater weight on present information and positive benefits. As mentioned above, with limited time to interpret and code for regulatory changes and constrained development resources, decision-makers may focus on the positive aspects of their internally-generated system. While a poor system is better than no system, the accuracy of the coded rules is no guarantee. 

    Compliance teams need to recognise that there is no competitive advantage to writing your own rules. In fact, it’s much better to work together to create the most accurate and up-to-date rule-set in the industry #strengthinnumbers. To find out how our managed Shareholding Disclosure service achieves this, get in touch.