Best Practices in Applied Behavioral Finance The Georgia Society of CPAs April 20, 2012 Presented by: Tyler D. Nunnally Founder & CEO Upside RISK
Nov 29, 2014
Best Practices in Applied Behavioral Finance
The Georgia Society of CPAsApril 20, 2012
Presented by:
Tyler D. Nunnally Founder & CEO
Upside RISK
Presentation Overview
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Part I: Introduction
Part II: Behavioral Finance 101
Part III: Risk Tolerance
Part IV: Best Practices
“Risk management is a form of engineering: it uses science, but ultimately depends on judgement… The ultimate protection against risk is good judgement and alertness: your own and that of your colleagues”.
Source: Risk Management, November 2005
“Mind the Gap” in ERM
© 2012 Upside Risk Corporation. All rights reserved.
Financial Crisis Inquiry Commission
“We conclude this financial crisis was avoidable. The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire… To paraphrase Shakespeare, the fault lies not in the stars, but in us”.
Source: http://www.fcic.gov/
Presenter Background
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‘92 Summer Olympic Games (Barcelona, Spain)
‘93 Nunnally International Trade, Inc. (Prague, Czech Republic)
‘03 University of St Andrews (St Andrews, Scotland)
‘04 Global Business Consulting (Barcelona, Spain)
‘06 Oxford Risk Research & Analysis Ltd (Oxford, England)
’09 Upside RISK (Atlanta, Georgia, USA)
© 2010 Upside Risk Corporation. All rights reserved.
PART II:
Behavioral Finance
101
What is Judgment Risk?
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Probability
of
Occurrence
Behavioral Biases
RiskX
Magnitude
of
Likely Impact
Risk Tolerance
“JUDGMENT RISK”
The Way People Make Decisions
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SYSTEM 1
(Intuitive)
SYSTEM 2
(Reason)
Automatic
Spontaneous
Unconscious
Instinctive
“Gut feel”
Thoughtful
Controlled
Informed
Deductive
Analytical
Sample Size Bias
© 2012 Upside Risk Corporation. All rights reserved.
There are 2 banks that serve Chester County. On average, the larger bank records $45 million deposits per day and the smaller bank records about $15 million deposits per day. The exact percentage varies from day to day. For a period 1 year, each bank recorded the days on which more than 60% of deposits fell above or below their daily averages.
Which bank do you think recorded more such days?
A. Large bank
B. Small bank
C. Same for both banks
D. Neither bank recorded such day
Behavioral Biases
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Booms and Busts: Housing market and subprime loans
Behavioral Biases:
- Time Discounting
- Confirmation Bias
- Loss Aversion
- Herding
- Overconfidence
Overconfidence
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“I Guarantee It”
• 90% drivers say they are “above average”
• 94% professors think they are “better than average”
• Majority of MBA believe they will fair better than classmates
Interventions:
• Think it through
• Do not act purely on intuition
• Ask for second opinion but avoid “yes men”
Time Discounting
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“Buy Now – Pay Later”
• Explosive growth of credit card industry
• Short-term strategies (analysts expectations)
• Long-term consequences (systemic risk)
Interventions:
• Think ahead
• Impact of decision in 5 years time – longer when stakes are high
• Imagine yourself and family in 5, 10 – 20 years
Confirmation Bias
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“Don’t Rock the Boat”
• Group Think
• Risky Shift
• Dangerous Risk Culture
Interventions:
• Devil’s advocate
• Avoid “yes men”
• Triangulate data
Status Quo Bias
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“Risk Avoidance is our Strategy”
• Loss aversion
• Failure to adapt… left behind
• Missed opportunities
Interventions:
• Atari, Xerox, Woolworths, Gateway, Kodak, RIM…
• Recruit some risk-takers and DEVELOP them
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PART III:
Risk Tolerance
Risk Domains
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Risk Propensities Compartmentalized into Separate Domains
RISK
DOMAINS
FinancialHealth/Safety
Recreation Ethical Social
For instance, a heavy drinker and smoker may take health risks, but
he is not necessarily the same guy who makes high risk investments
with his 401(k).
Risk Profiling
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Key Factors in Financial Planning
• Resources
• Goals
• Time Horizons
• Rick Capacity
• Risk Tolerance
Risk Profiling
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Risk Parameters in Achieving Desired Outcomes
• Risk RequiredHow much risk do you need to take
• Risk CapacityHow much risk can you afford to take
• Risk ToleranceHow much risk do you prefer to take
Perception of Risk
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Perception of how “risky” something is often determined by how readily
examples come to mind from memory. Bias occurs when probability
assumptions become inflated by recent events.
US AIRLINE INDUSTRY PASSENGER REVENUES 1999-2004
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PART IV:
Best Practices
“Mind the Gap” in ERM
© 2012 Upside Risk Corporation. All rights reserved.
Upside Risk analysis of common human factors found in subprime related securities class action lawsuits:
1. Perverse compensation and incentives structures2. Lack of policy enforcement3. Inadequate internal controls4. Conflicts of interest / Breach of Fiduciary Duties5. Short-term focus on high risk growth strategies
Source: http://securities.stanford.edu/litigation_activity.html
Governance, Risk & Compliance
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Plan of Action to Mitigate Behavioral Risks
1. Pre-employment risk assessment to identify right and wrong “type” of
people
2. Incorporate risk requirements into job descriptions
3. Design and deliver risk training and leadership development programs
4. Develop financial incentive structures that reward fulfillment of
long-term business objectives
5. Create compliance program that rewards adherence to policy and
punishes non-compliance
6. Enforce risk and compliance policies
7. Monitor and benchmark behavioral change (quarterly)
Blind Spot Assessment
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Key Risk Factor Category Risk Exposure
Judgment Bias
Sample Size Bias Probabilities and Statistics Low
Base Rate Bias Probabilities and Statistics Very High
Conjunction Fallacy Probabilities and Statistics Very High
Gamblers Fallacy Probabilities and Statistics Very Low
Overconfidence (Perception) Behavioral Bias High
Time Discounting Behavioral Bias Very High
Overconfidence (Actual) Behavioral Bias Moderate
Confirmation Bias Behavioral Bias Low
Illusion Of Validity Behavioral Bias Very High
Status Quo Bias Behavioral Bias Very Low
Herding Behavioral Bias Moderate
Framing Effects Behavioral Bias Moderate
OVERALL High
Risk Appetite
Status Quo Choice Dilemmas High
Sunk Cost Loss Choice Dilemmas High
Sunk Cost Gain Choice Dilemmas Low
Perception Investment Decisions Low
Benefits Investment Decisions Moderate
Behavioral Bias Investment Decisions Moderate
Willingness to Pay Risk vs. Reward Very High
Low Stakes Lottery Choice Moderate
High Stakes Lottery Choice Moderate
OVERALL High
Blind Spot Assessment
© 2012 Upside Risk Corporation. All rights reserved.
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.20 0.30 0.40 0.50 0.60 0.70 0.80
Risk Appetite
Ju
dg
me
nt
Bia
s
John Doe
Sample Population
Predictive Analytics
© 2012 Upside Risk Corporation. All rights reserved.
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.20 0.30 0.40 0.50 0.60 0.70 0.80
Risk Appetite
Ju
dg
men
t B
ias
A
B
C
D
E
F
Sample Population
© 2012 Upside Risk Corporation. All rights reserved.
Tyler D. Nunnally, Founder & CEO
Upside RISKAtlanta, Georgia U.S.A.
Phone: +1.404.320.6047
Email: [email protected]
www.Upside-Risk.com