Download Behavioral Biases And Governance

Behavioral Biases And
Governance
How To Avoid Being Your Own
Worst Enemy
1
Peter D. Gerlings, CFA, CAIA
Copyright © 2015 by The Segal Group, Inc. All rights reserved.
Introduction
“When everyone thinks alike, everyone is likely to be wrong.” – Neill
“I find more and more that it is well to be on the side of the minority, since it is
always the more intelligent.” – Goethe
“The trouble with the world is that the stupid are cocksure and the intelligent are
full of doubt.” – Bertrand Russell
“Everyone has a plan until I hit them.” – Mike Tyson
•
Humans are hard-wired to make bad investment decisions
– Behavioral Biases
– Governance Pressures
•
Meanwhile, managing portfolios has become more complicated than ever
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Time horizon compression
Accelerating change
Sheer number of choices
Information deluge
How can investors cope?
– Examples
– Recommendations
Have You Seen These Behaviors?
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DC Plan Participants
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Spend little time planning for retirement
Don’t monitor their investments
Don’t optimize voluntary contributions
Under-choose target date funds
Under-select annuities
Over-react to the latest economic report
Few participants access the substantial
resources available about:
• Financial goal setting
• Investment alternatives
• Tax strategies
• Smart consumer practices
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Investment Committees
–
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Believe that committee members and
participants consistently make
decisions rationally and with relative
competence
Try to educate participants while
conveying a neutral point of view and
thereby under-emphasize intelligent
choices
Focus on “how we did lately” and
“what is the near term investment
outlook”
Make investment picks by glancing in
the
rear view mirror and relying on
charisma
Behavioral Biases Versus Optimal Investment
Decision Making
•
Premises
– Human beings have a profound tendency
towards making unprofitable investment
decisions
– The nature of governance can amplify poor
decision making tendencies
– All investment decisions involve some
combination of
• Rational thinking
• Mental shortcuts
• Emotion
– The world is becoming more complex
• And at an accelerating pace
• There is an arms race between investment
complexity and fiduciary bandwidth
Behavioral Biases Versus Optimal Investment
Decision Making
•
Premises
– Retirement plan participants may make more sub-optimal decisions, but members
of investment committees and their advisors are also human
– Organizations can impart their own biases on decision making
– The operating model of a committee should be structured to mitigate sub-optimal
decision-making resulting from behavioral and organizational biases
 Our Goals
– To explore some of the challenges and potential pitfalls faced by investment
committee and individual investors alike
– Introduce techniques from behavioral economics and finance which can help
improve investment outcomes
– Offer suggestions for next steps
Human Behavior Biases
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We Are Hard Wired To Make Poor Investment Decisions
– However, profitable investment decisions are not impossible to make
– And behavioral biases are not impossible to surmount
– The first challenge it to be aware of these biases and how they affect everyone
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The brain is a truly remarkable thing
– Especially when thought of as a “pattern recognition device”
• No computer comes close to its amazing speed and accuracy
• (Some programmers are determined to try, however)
– Unfortunately, the brain doesn’t know what it doesn’t know
• And can form spurious relationships
• And hold on to cherished myths
Human Behavior Biases
$6.00
A manifestation of how the
brain acts like a pattern
recognition device is called
“linear extrapolationism”
– The tendency to project
forward indefinitely the
trend we observe today
$5.50
$5.00
$4.50
$4.00
Manager (Projected Returns
in Blue)
$3.50
$3.00
Manager (Actual Returns)
Before an
investment
$2.50
$2.00
$1.50
After an
investment
decision
$1.00
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
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Human Behavior Biases
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Linear Extrapolation Bias
– Our brains really want to extend trend-lines indefinitely into the future
• It’s why securities’ prices vary far in excess of what’s suggested by their
underlying fundamentals
• Bubbles and their painful crashes are manifestations of this phenomenon
• As a species, we never seem to learn
•
Confirmation Bias
– Seek out information that supports existing views
– Discounts information which conflicts with existing views
Human Behavior Biases
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Attribution Error
– Assigning positive motivations and/or attributes to our group
• “But officer, I was speeding because I’m late for something really important!”
– Negative motivations and/or attributes to those outside our group
• “Hey – that jerk is speeding! I hope he gets a ticket!”
– Closely related to false confidence
• “Everyone is stupid but me”
Human Behavior Biases
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Bias towards the Status Quo
– “5 Monkeys, a banana and a fire hose”
• Creates enormous inertia
• Often irrational
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Groupthink
– Herd mentality
• “Everyone has to be like Yale”
• Peer group obsession
– Better to fail conventionally than succeed unconventionally
– “No one ever got fired for hiring IBM”
– “None of us is as dumb as all of us”
Human Behavior Biases
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Bias Bias
– “Every has biases but me”
– Dunning-Kruger Effect – the
inverse relationship between
how much we actually know
about something, versus how
much we think we think we
know about it
Governance
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Governance is a Human Construct
– And is therefore subject to Human biases, and especially
• Appeals to authority
• Group think
– But in addition, there are the following challenges:
• Living in a fishbowl
– Decisions are often second guessed by people with
» Less experience
» Less relevant knowledge
– College/University Endowments are particularly impacted by this
» Student advocacy
» Various outside constituents
• Career risk management
– Someone else might be doing your job if you’re not “careful”
Governance
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The Impact of Behavioral Biases and Governance Pressures leads many
investors to
– Buy high and sell low
• Occurs at both the manager and the asset class level
– Are typically invested in only after they have gone up in value
– Are typically divested from only after they have gone down in value
• The excuses always sound the same
– “Look how good they appeared when we made the decision to hire them!”
– “How could I have possibly known they would eventually underperform?”
– Made worse by the “No one ever got fired for hiring IBM” phenomenon
• Significant value is destroyed during the manager search process
– Majority of asset managers underperform after they have been selected
– Majority of asset managers outperform after they have been terminated
Governance
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The Impact of Behavioral Biases and Governance Pressures leads many
investors to
– Follow the herd
• Clustering around certain asset classes, managers
• Made much worse by “Horse Race” mentality
– Everyone “must” be in the top quartile
– Individual circumstances (liquidity needs, time horizons, etc.) too often ignored
when comparing results
• Made worse still by the “Cocktail Party” effect
– People like to brag about their investments
– It’s no fun watching your neighbor make more many than you do
– But also overestimate their own capabilities
• Especially relative to third-party options (agency/principal bias)
• Be overly optimistic
Increasing Complexity
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Apart from all the biases discussed earlier, investors today are confronted by
increasing complexity
And not only are investments MUCH more complicated than they were
– The rate of change is accelerating
• Explosion of information
– Human knowledge doubles every 7 years
– It feels linear when we look at history, but in fact it is geometric going forward
• Think of the movie “Back to the Future”
– It was made in 1985
– Marty McFly went back to 1955
– The pace of advancement between 2015 and 1985 is arguably greater than between
1955 and 1985
»
»
»
Smart phones
Internet
GPS
Increasing Complexity
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1980s and earlier
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Balanced Portfolios
Mostly U.S. focused
Relatively few managers (sometimes only 1!)
Quarterly (sometimes just annual) reporting
Increasing Complexity
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1990s-2000s
– Asset class specialization
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U.S. Equities
U.S. Bonds
Foreign Equities
Foreign Bonds
Tactical Asset Allocation
Real Estate
Alternative Assets
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Private Equity
Hedge Funds
• Many more managers, sometimes dozens
Increasing Complexity
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2010s and beyond
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Smart Beta
Infrastructure
Liquid Alternatives
Tail-risk management
Overlay strategies
Etc.
Lots and lots of managers
Increasing Complexity
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The future?
– Hard to predict, but it seems reasonable to expect
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•
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More complexity
More information to process
More compressed decision making
No guarantee that there will be more time and resources with which to manage
all this complexity
Increasing Complexity
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In a way, we have gone full circle
– Back in the 1980s
• Most endowments and foundations were 100% outsourced
– Local bank trust department
– Maybe a few external asset managers
– In the 1990s, asset class specialization put decisions back into investors’
hands
• Asset allocation
• Manager selection
• Rebalancing
Increasing Complexity
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The trend towards complexity has only accelerated into 2015
– Style specialization
– Direct hedge fund investing
– Tactical risk/rebalancing tools
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We’re back to having many decisions made by investment committees
– But often without appropriate resources and/or training
– And often unable to keep up with accelerating change
Example: Manager Selection Problem
Which Manager Would You Pick?
Manager A
Manager B
Assets Under Management
$20 Billion
$7.2 Million
Clients
Over 100, including
sophisticated investors and
well-known families
11 Doctors
Results
Average annual 10 years of
25%; volatility 2%/year
Average annual 6 years of
25%; volatility 14%/year
Portfolio
Basket of S&P 100 stocks
with options strategy
30-40 stocks
Offices
New York and London
Omaha, Nebraska
Answer
Manager A
Manager B
Bernie Madoff
Warren Buffett
Examples of Bias and Response
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•
Annualized Returns
Recency Bias
LastQ
YTD
1 Yr.
3 Yr.
5 Yr.
10 Yr.
Small Cap Growth (Gross)
16.7%
28.0%
29.1%
24.7%
12.6%
14.4%
Small Cap Growth (Net)
16.5%
27.5%
28.2%
23.8%
11.8%
12.8%
Russell 2000 Growth Index
3.7%
17.4%
23.7%
20.0%
8.9%
9.6%
Solution: Avoid the “hot dot”; avoid “lucky idiots” at all costs
Hot Dots Versus Future Performance
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Assume you can pick between portfolios
– Portfolio A - Up 20% over the last year
– Portfolio B - Down 20% over the last year
– Which portfolio would you expect to do better over the NEXT 12 months?
• Assuming that there is anything less than 100% turnover in both portfolios
– All other things being equal, Portfolio B now has more attractive valuation
characteristics than Portfolio A
– Over the long run, valuation matters
(It should be said that there are LOT of factors which influence future performance, and
many are simply unknowable in advance. However, the impact of recent performance
on relative valuation is too often ignored.)
Examples of Bias and Response
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Choice Paralysis: “Let’s give both managers money.”
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Solution: Establish a disciplined set of criteria with a scorecard
Examples of Bias and Response
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Optimism Bias: “We can select winners after four 30-minute
presentations.”
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Solution
– Revisit process and past results
– Do a governance checkup
Examples of Bias and Response
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Bias Towards Herding
– Chasing investments made by other funds
– Amplified when investors are considered “sophisticated”
– Investments considered attractive, even though they may not meet the specific
and unique circumstances for that investor
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Solution
– Consider each investments potential on your unique circumstances
– How does it impact my liquidity? Time Horizon? Risk Profile?
Examples of Bias and Response
• Bias Blind Spot: “Sure, a lot of people let these things get in their way, but not us.”
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Solution: Team building exercises
Suggestions for Investment Committees
Creating High Performing Teams
Form Committees
with Diverse
Perspectives
Conduct Periodic
Training on Bias
Avoidance and
Framing Effects
Align Advisors’
Framings with
Investment Policy
Execute an
Operating
Model
Designed to
Avoid Making
Suboptimal
Decisions
Suggestions for Investment Committees
• Experiencing Behavioral
Bias First Hand
• Informative Research and
Applications for Your
Business
• Reflecting on Past
Committee Biases
• Planning: Revise the
Committee Operating
Model
Applied to Key Activities
• Availability Heuristic
• Comparative Competence
• Complexity Aversion
• Confirmation Bias
• Endowment Effect
• Familiarity Bias
• Gambler’s Fallacy
• Groupthink Bias
• Halo Effect
• Hindsight Bias
• Loss Aversion
• Mental Accounting
• Narrative Fallacy
• Optimism Bias
• Outcome Bias
• Probability Neglect
• Recency Bias
• Regressive v. Exaggeration Biases
• Risk Aversion and Risk Seeking Biases
• Sample Size Neglect Bias
• Status Quo Bias
• Sunk Cost
Curriculum
Human Biases
Creating High Performing Teams
•Selecting Investment Options
•Selecting Defaults
•Communicating Fund Options to
Participants
•Offering Participant Education
Sessions
•Revisiting the Investment Policy
Statement
•Reviewing Fund Performance
•Rebalancing the Portfolio
•Evaluating Proposals
•Checking References
Summary: How to Manage All This
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Despite the complicated (and possibly bleak) picture painted so far, there is hope for
investors
– Awareness of our biases is an important first step
• Not all can be completely overcome (and remember “bias bias”)
• But if we’re aware of our bad tendencies, we can work to mitigate their impact
– There are groups out there (including Segal Rogerscasey) that can help with
governance issues
• Fiduciary outsourcing
• Committee education/training
• Improved communications/analytics
– The trick is to optimize the combination of internal resources and external
resources
Thank You