Download Educating Your Investment Committee on Behavioral Economics

Consulting Group
EducatingYour Investment Committee on
Behavioral Economics
Gary W. Jbara, CIMA® – Executive Director – Senior Institutional Consultant
Mark J. Rogers, CIMA® – Executive Director – Senior Institutional Consultant
Farmington Hills, MI - Kalamazoo, MI - Chicago, IL
http://www.morganstanleyfa.com/jbaraandrogers
(800) 819-0949
Investment committee members have a lot to
think about.
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CMF Annual Conference 2014
Understanding Behavioral Economics Leads to
Better Decision Making
In this session we will…
• Discover How We Think
• Understand How Our Minds Play Tricks On Us
• Learn to Overcome Hurdles to Becoming Better
Investors
• Summarize How You Can Help Your Investment
Committee Make Rational Investment Decisions
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Discover How We Think
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What is Behavioral Economics?
Behavioral economics explores why people sometimes
make irrational decisions, and why and how their behavior
does not follow the predictions of economic models.
“Our comforting conviction that the world makes sense
rests on a secure foundation: our almost unlimited
ability to ignore our ignorance.”
― Noble Prize Winner Daniel Kahneman, Thinking, Fast
and Slow
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Game of Catch: Count the Number of Passes
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Game of Catch: Focus
Did you see the gorilla?
Lack of Focus: Inability to see the whole picture
Examples in investments:
• Quarterly benchmarking
• Improperly assessing risk adjusted returns
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Answer the Questions Below
10.
Martin Luther King's age at death
Length of the Nile River (in miles)
Number of countries that are members of OPEC
Number of books in the Old Testament (King James Version)
Diameter of the moon in miles
Weight of an empty Boeing 747 (in pounds)
Year in which Wolfgang Amadeus Mozart was born
Gestation period (in days) of an Asian elephant
Air distance from London to Tokyo
Deepest (known) point in the ocean (in feet).
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1.
2.
3.
4.
5.
6.
7.
8.
9.
Estimate
Low
High
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
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____
____
____
____
____
Answers
1. 39 years
2. 4,187 miles
3. 13 countries
4. 39 books
5. 2,160 miles
6. 390,000 pounds
7. 1756
8. 645 days
9. 5,959 miles
10.36,198 feet
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Overconfidence:
A well-established bias in which one's
subjective confidence in their judgments is reliably greater
than their objective accuracy, especially when confidence
is relatively high.
Examples in investments:
– Portfolio: Change in strategic allocation based solely
on recent results
– Investment Vehicle:
• Equity market index
• Specific active manager
• Specific investment style
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Understanding How Our Minds
Play Tricks On Us
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Count the White Dots
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Discover Your Mental Shortcuts
Now look at these two lines. Can you tell me which one looks longer?
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Thinking Fast and Thinking Slow1
System 1 (FAST)
System 2 (SLOW)
• Unconscious
• Controlled Mental Process
• Effortless
• Effortful
• Automatic
• Deliberate
Role:
• Assesses the situation
• Delivers updates
When does this kick in?
• Speed of reaction counts
Role:
• Seeks new/missing information
• Makes decisions
When does this kick in?
• When system 1 can not process data
Fast thinkers tend to see the Gorilla and
struggle to count the white dots
Slow thinkers tend to miss the Gorilla, but
count the white dots
1Kahneman,
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Daniel. Thinking, Fast and Slow. New York: Farrar, Straus and Giroux, 2011.
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Overcoming Hurdles to
Becoming Better Investors
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Become a Better Investor
Overcome Four Hurdles to Become a
Better Investor
1. Anchoring
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2. Herding
3. Confirmation
Bias
4. Framing
Was Mahatma Ghandi more or less than 144 years
old when he died?
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How old was Mahatma Ghandi when he died?
Answer: 78 years old
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Anchoring:
The tendency to rely too heavily on the first piece of
information offered (the "anchor") when making decisions
Example in investments:
– The traditional 60/40 portfolio
– Home country bias
– Hedge funds in a portfolio
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Hoist Your Anchors
• Objectivity should be a fundamental part of your
investment policy review.
• Look at your investments and ask, if you were
starting over, would you choose that strategy in
today’s environment?
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Become a Better Investor
Overcome Four Hurdles to Become a
Better Investor
1. Anchoring
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2. Herding
3. Confirmation
Bias
4. Framing
Blinded by the Herd
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Herding in the Stock Market
S&P 500 Index Performance vs. 12-Month Equity Mutual Fund Flows
$400
$14,000
$300
$12,000
$10,000
$200
$8,000
$100
$6,000
$0
$4,000
-$100
$2,000
-$200
12/00
12/02
12/04
Net Equity Mutual Fund Flows (billions)
12/06
12/08
$0
12/10
Growth of $10,000 in S&P 500 Index
Sources: BlackRock; Informa Investment Solutions; DB US Equity Strategy; Investment Company Institute (US mutual funds and ETFs). The S&P 500 Index is an unmanaged index that
consists of the common stock of 500 large-capitalization companies, within various industrial sectors, most of which are listed on the New York Stock Exchange. Returns assume
reinvestment of dividends. It is not possible to invest directly in an index. Past performance is no guarantee of future results. The information provided is for illustrative purposes only and is
not meant to represent the performance of any particular investment.
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Set Yourself Apart
“If you want to have a better performance than
the crowd, you must do things differently from
the crowd.”
–John Templeton
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Avoid Following the Herd (Although it’s Warmer There)
• Take steps now to ensure you are not just following the
crowd
– Broaden asset allocation guidelines in Investment
Policy Statements
– Develop an all-weather portfolio
• Consider index management as a core component
• Incorporate active management as a satellite
component
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Become a Better Investor
Overcome Four Hurdles to Become A
Better Investor
1. Anchoring
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2. Herding
3. Confirmation
Bias
4. Framing
Vary Your Sources for News
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Confirmation bias:
Tendency to accept data confirming beliefs and ignore data to
the contrary
Examples in investments:
– Challenge of objectively looking at investments once placed
– Preference towards familiar strategies
– Rejecting new strategies (Impact Investing)
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Recognize Confirmation Bias
• Consider mission first
– Maintain an open mind
– Adhere to fiduciary duties
– Vary sources of information and analysis
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Become a Better Investor
Overcome Four Hurdles to Become A
Better Investor
1. Anchoring
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2. Herding
3. Confirmation
Bias
4. Framing
Is the Glass Half Empty or Half Full?
69% of people
“half empty”
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88% of people
“half full”
Would You Rather Have…
A
B
50% Chance:
$300
$150
50% chance:
$0
Risk averse
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Risk seeking
Dislike of Uncertainty:
Most people choose “A”
Why: Attitude toward risk taking; difficulty in thinking in
terms of probabilities
– Most investors prefer a guaranteed positive outcome rather
than unknown outcome with potentially greater returns
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Would You Rather Lose…
A
B
50% Chance:
$0
-$150
50% chance:
-$300
Risk averse
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Risk seeking
Loss Aversion:
Most people choose “B”
Why: Avoiding a loss even if it means accepting a higher
risk
– Hanging on to losers and selling winners
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Develop A Frame of Neutrality
• Understand your personal framework
• Balance knowledge and instinct
• Rely on your financial consultant for leadership
– Ask them to play devil’s advocate
– Ask them to provide education on financial topics
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Summary: How to Help Your
Investment Committee Make
Rational Investment Decisions
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How to Help Your Investment Committee Make
Rational Investment Decisions
1. Think fast and slow in every decision
2. Act rationally when markets display negative volatility or
skies are too blue
3. Recognize these common behavioral finance mistakes and
the tendency to repeat them
4. Challenge your investment consultant to provide leadership
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Appendix: Speaker Biographies
and Disclaimers
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Gary W. Jbara, CIMA®
Executive Director, Financial Advisor
Senior Institutional Consultant
Senior Investment Management Consultant
 Senior partner and founding member of the Group
 IMCA Certified Investment Management AnalystsSM(CIMA®) designation from
Wharton School of Business, University of Pennsylvania.
 Member of Investment Management Consultants Association (IMCA)
 Member of the Association of Professional Investment Consultants (APIC)
 Speaker at national industry conferences presenting on balancing spending and
investment policies, asset allocation strategies using both traditional and
alternative asset classes, and alpha strategies
 Bachelors of Science in Mathematics and Business from
the University of Notre Dame
 Master of Business Administration from the University of Michigan
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Mark J. Rogers, CIMA®
Executive Director, Financial Advisor
Family Wealth Director
Senior Investment Management Consultant
 Senior partner and founding member of the Group.
 IMCA Certified Investment Management AnalystsSM(CIMA®) designation from
Wharton School of Business, University of Pennsylvania.
 Member of Investment Management Consultants Association (IMCA)
 Member of the Association of Professional Investment Consultants (APIC)
 Provides thought leadership through presentations on market and economic
updates, risk management policies to avoid market boom/bust cycles, how to
make effective investment decisions, mission investing and planned giving.
 Bachelors of Arts in Business Economics from Michigan State University
 Member of Morgan Stanley’s Investing with Impact Champion’s Council
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Joel J. Moore
Second Vice President
Relationship Manager
Investment Professional since 2002








Relationship manager for foundation/endowment client division of the Group.
Earned Accredited Investment Fiduciary from the Center for Fiduciary Studies
Member of the Association of Professional Investment Consultants (APIC)
Speaker at industry conferences presenting on spending and investment
policies, asset allocation strategies using both traditional and alternative asset
classes; alpha strategies and other topics.
Indiana Grantmakers Alliance Education Advisory Committee member
Bachelor of Science from Rockford University
Board of Regents Member at Rockford University
Member of the Council of Michigan Foundations (CMF) Impact Investing Task
Force
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John G. Rogers
Financial Advisor
Investment Professional since 2013
 Mission Related Investments Team Liaison.
 Consulting Group Product Specialist at Morgan Stanley Institutional
Headquarters in Wilmington, DE, July 2012 – April 2013.
 Graduated from Northwestern University in 2012 with a Bachelor of Arts in
History, Minor in Business Institutions and Certificate from the Undergraduate
Leadership Program (UGL).
 Member of the Youth Advisory Council for the Children’s Leukemia Foundation
of Michigan.
 Member of Morgan Stanley’s Investing with Impact Champion’s Council
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Disclosures
An investment in alternative investments can be highly illiquid, is speculative and not suitable for all
investors. Investing in alternative investments is only intended for experienced and sophisticated
investors who are willing to bear the high economic risks associated with such an investment.
Investors should carefully review and consider potential risks before investing. Some of these risks
may include:
• loss of all or a substantial portion of the investment due to leveraging, short-selling, or other
speculative practices;
• lack of liquidity in that there may be no secondary market for the fund and none is expected to
develop;
• volatility of returns;
• restrictions on transferring interests;
• potential lack of diversification and resulting higher risk due to concentration of trading authority
when a single advisor is utilized;
• absence of information regarding valuations and pricing;
• complex tax structures and delays in tax reporting;
• less regulation and higher fees than mutual funds; and manager risk.
Individual funds will have specific risks related to their investment programs that will vary from fund to
fund.
Actual results may vary and past performance is no guarantee of future results.
© 2014 Morgan Stanley Smith Barney LLC. Member SIPC. Consulting Group and
Investment Advisory Services are divisions of Morgan Stanley Smith Barney LLC.
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Sources
• Kahneman, Daniel. Thinking, Fast and Slow. New York: Farrar, Straus and Giroux, 2011.
• Selective Attention Test: The Invisible Gorilla. The original, world-famous awareness test
from Daniel Simons and Christopher Chabris.
• Some information in this presentation was obtained from Northwestern University's CIO
William McClain
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