Consultiva Internacional, Inc. Third Annual Investment Management Conference November 15, 2002
Jun 25, 2015
Consultiva Internacional, Inc.Third Annual Investment Management Conference
November 15, 2002
The Human Element…
How it affects Individual and Institutional Investing Decisions
Javier Rubio, CFAMario Iturrino
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The Human ElementThe Human Element in: in: 1) Individual Investors
2) Institutional Investors 3) Investment Committees
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1) The Human Element in Individual Investors:
The following three elements have a significant effect on individual decision making process
Preferences (Risk Profiles) Over-confidence Regret
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a) Risk Profiles (Loss Aversion) 1) You Receive $1000
2) Now Choose Between
a) A sure gain of $500 b) A 50% chance to win $1000 and 50% chance of
$0
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1) You Receive $2000
2) Now Choose Between
a) A sure loss of $500 b) A 50% chance of no loss and 50% to lose
$1000
a) Risk Profiles (Loss Aversion)
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a) Loss Aversion Gamblers’ Results:
A) 84% Choose the Sure Thing: $1000 + $500 = $1500, zero variance
B) 69% Choose to Gamble: $2000 less either $0 or $1000 = $2000
or $1000
Conclusions: People hate losses more than they like
gains
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a) Loss Aversion Utility Function
Paul Samuelson’s wager:
Coin toss: win $200, lose $100 Probability: (.5 x 200) + (.5 x –100) = $50
Colleague’s response: “no”
Myopic Loss Aversion and the Equity Premium Puzzle, Shlomo Benartzi and Richard Taylor, Quarterly Journal of Economics 1998
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b) Over-confidence…
“Some people will have accidents,
but not us.” 90% of Drivers in Sweden “Above Average” Some people will have stupid kids, “but ours will be gifted.”
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b) Over-confidence “What is the Expected Return of Stocks?”
(High expected returns follow high realized returns)
Sept. 1999
Sept. 2001
15% 40%39.8%
-24.4%
13.2%6.3%Expected
Return on Market
S&P Return during the
preceding 12 months
Source: Gallup
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b) Over-confidence
“What is the Expected Return of YOUR Stocks?” (I will do better than the market)
Sept. 1999
Sept. 2001
14.9%
13.2% 6.3
%
7.9%
Own portfolio
Stock Market
Source: Gallup
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b) Over-confidence “Is the market overvalued?”An overvalued market offers higher expected returns….
Sept. 1999
Sept. 2001
50 15%49
2713.2%
6.3%
Expected Return on Market
Overvalued
Source: Gallup
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b) Over-confidence “Is this a good time to invest?”
Yes …but the market is overvalued
Sept. 1999
Sept. 2001
49%
27%
72%53%
Overvalued
Good Time to Invest
Source: Gallup
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c) Regret
Why didn’t I sell when the NASDAQ was at 5,000?
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What do investors want?
Investors are:
Rational -consider portfolios as a whole:
Standard (mean-variance) Portfolio
Investors are:
Emotional
- risk-averse AND risk-seeking
-portfolios as mental accounts:
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2) The Human Element in Institutional Investors:
Overconfidence Pattern Recognition
Following the CrowdStyle Traps
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a) Over-confidence:a) Over-confidence:
Pattern RecognitionPattern Recognition
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a) Over-confidence:a) Over-confidence: Pattern RecognitionPattern Recognition
Touch a button, S or B
You win (money or food) if the choice is right.
S B
a) Over-confidence:er-confidence:
Pattern RecognitionPattern Recognition
Human vs Rat Intelligence:
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0%
20%
40%
60%
80%
100%
1 2 3 4 5
Men
Rats
Time
Touching Button S
B
S 4/5 chance of winning
1/5 chance of winning
a) Over-confidence:er-confidence:
Pattern RecognitionPattern Recognition
Never
4/5
AlwaysRats
Humans
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a) Overconfidence Barron’s Annual Roundtable*
Wall Street Super-stars24 years, 1751 recommendations1599 buys, 152 sellsBuys
+1.9% Before Publication 0.0% After Publication
Sells –1.2% Before Publication -8.1% After Publication
Journal of Finance, Sept 1995, H. Desai and P.C. Jain
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b) Traps in Active ManagementTraps of Active Management
-1.2
0
1.2
0
Hate
Curiousity
Interest
Concern
Conviction
Love
Panic
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b) Other Traps
Are We too Greedy? Assets Under Management…
Data OverloadWhat’s Already in the Price?
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3) The Human Element in Investment Committees:
The Beauty Contest Following the CrowdAgent Risks & The Prudent Man RuleOver-confidence vs Random Events The Hot Hand The Search for Skill
a) The Beauty Contest
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Match client needs with agent skills
Agents acting wholly on behalf of
principals
Avoiding potential for divergent
motives
c) Agent Risks & The “Prudent Man Rule”
XYZ Company
Pension Fund
Investment Board
(Onlookers?)
Beneficiaries
c) Agent Risks
Evaluation versus Planning Horizons
Money Managers
Horizon = Forever
CFO
Pension Staff
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Horizon = 3-5 Years
Horizon = Forever
Horizon = 3-5 Years
Horizon = 30 Years
Consultants (Education…
Blame?)
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c) Agent Risks Myopic Loss Aversion:
Evaluation Horizon drives Asset Allocation…Not the Planning Horizon (Portfolio Life)Longer Evaluation Horizon… More Stocks More willingness to assume risk
Aspects of Investor Psychology Daniel Kahneman & Mark Riepe, Journal of Portfolio Management, Summer 1998
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c) Agent Risks & The “Prudent Man Rule”
Gain (loss)
Undisclosed Perceptions, Inc.Crispy Cream Diet CentersHarley Safety EquipmentBoston Red Sox B Shares New Orleans Health Foods
TOTAL
200,000200,000200,000200,000200,000
1,000,000
300,000310,000280,000120,000260,000
1,270,000
100,000110,000
80,000(80,000)
60,000
270,000
Cost Market
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4 in a row 50%
5 in a row 25%
6 in a row 20%
20 Coin FlipsHeads or Tails % Chance
d) Overconfidence vs Random Events
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d) Overconfidence vs Random Events
Prescription:
Result:
Compare to:
On Jan. 1, 1991 select last years top performing newsletter in Hulbert’s Digest. Invest $100,000. Follow advice for 1 year. Repeat process on each Jan. 1st investing assets at previous year’s end in hottest newsletter of previous year.
10 years ending December 31, 2000Your money = $70,752 (-3.4%/year)
S&P 500 = $497,371 (17.4%/year)
*Source: Mark Hulbert, New York Times, Sunday, Jan 21, 2001
d) Overconfidence vs Random Events
1
3
2
4
Where did first quartile managers come from?
QU
AR
TIL
EWhere did first quartile managers go?
8
8
11
14
41 8
16
11
6
41
1991-94 1995-98 1991-94 1995-98
Universe consisted of 162 institutional managers in Russell’s Growth, Market-Oriented,
and Value universes with 8 years of history ending 1998.
Example: Of the 41 managers in the top quartile for years 1991-1994,only 8 remained in the first quartile in years 1995-1998.
Source: Frank Russell Company
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100 Dart Throwers
100 Unskilled Managers
100 Skilled Managers
Statistically, how many managers will outperform the market?
(Assume skilled and skilled have mirror image +/- IRs)
50
46
54
50
43
57
50
41
59
1 year 5 years3 years
d) Overconfidence vs Random Events The Search for Skill
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d) Overconfidence vs Random Events Excess Returns are Variable (Alpha = 3%, Std Dev 6%, Info Ratio 0.50)
Continuous Underperformance for: 3 years: 20 times 4 years: 8 times 5 years: 3 times
Underwater vs Benchmark (DrawDown) for: 3 years: 66 times 10 years: 10 times 23 years: 1 time
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Conclusion
Human predispositions interfere with sound investment decision at all levels, including:
Individual decisions Institutional investment strategies Investment committee decisions
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Recommendations
Be aware of potential pitfalls and traps
Have a well thought out long-term investment plan
Although adjustments are recommended, stick to your plan
Make rational decisions, avoid emotional interference
Always make decisions on a portfolio context