In April this year, Jamie Dimon, chief executive of JP Morgan Chase, called concerns about the bank’s hedging strategy a “tempest in a teacup”. It is a comment he lived to regret, as the bank admitted in May that it suffered about $2bn in losses on large, opaque and complicated derivatives trades.
For some, Dimon’s comments illustrate a systemic problem best explained by behavioural finance. In contrast to the efficient markets theory, behavioural finance holds that individuals often make investment decisions based on irrational factors.
According to this view, investment professionals can be overconfident, secure in their world view and prone to denial. Sheetal Radia, policy adviser for the CFA Society of the UK, the association of investment professionals, believes that people don’t seem to have learnt lessons from mistakes made in previous financial crises. He said: “We never want to look at the root causes of the problem, only the symptoms.”
In a CFA UK paper “Why do we keep forgetting – and how do we start remembering?” Radia highlights four behavioural traits. They are: cognitive dissonance, the dismissal of views that are in opposition to your own; herding and “groupthink”; the illusion of control and overconfidence; and the disposition effect, where market participants prefer not to realise loss-making positions, even though this can mean taking great risks, in the hope that the situation changes.
Behavioural finance has evolved since the financial crisis, with several schools of thought ranging from behavioural portfolio theory, to emotional finance, in an effort to explain why people and markets behaved the way they did. But how useful is behavioural finance in preventing us from making similar mistakes in the future?
Klement suggests the industry should keep investment diaries to record manager actions, such as buying and selling, allowing them to look back and detect patterns in their decision-making. Managers should make a quick note of their rationale for each decision and the risk they are taking, much as pilots go through a checklist before each flight. He said: “The investment diary is three short bullet points, what did you do and why you did it and what could go wrong. It’s a very quick exercise that helps you memorise these things and retrieve them.”
Some investment professionals, particularly in private banking, have shown interest in the diary system, according to Klement.
Others also see the practical value of behavioural finance. Research by manager evaluation firm Inalytics found that truly skillful fund managers have three characteristics. They get more than half their decisions right, are able to run their winning stocks (without selling too early) and they are able to cut their losing stocks without holding on in the hopes that things will turn around.
Inalytics’ research shows that managers who are able to run their winners and cut their losers outperform their peer group by 5% per year. Di Mascio says Inalytics’ business of researching and quantifying manager skill and conducting due diligence for asset managers and asset owners has more than doubled in the past year, as these investors look to use behavioural factors to measure performance.
There are also developments in portfolio theory. In the 1950s Nobel Prize-winning economist Harry Markowitz advocated the mean-variance theory, whereby investors focus on their portfolios as a whole, on the choice of portfolio weights that provide an optimal trade-off between the mean and the variance of the portfolio return.
In 2010 he presented a mental accounting portfolio theory, which argues that investors have mental account layers that are associated with particular goals and where attitudes toward risk vary across layers, alongside fellow academics Sanjiv Ranjan Das, Jonathan Scheid, and Meir Statman. Statman, who is the Glenn Klimek professor of finance at the Leavey School of Business at Santa Clara University and the author of What Investors Really Want, said: “Mental accounting portfolio theory is a good example of where behavioural finance can help investors.
CFA UK’s Radia has come up with four solutions to investors’ financial amnesia. First, the practical history of financial markets should be taught to investment professionals. Second, an index to monitor credit growth and financial innovation should be developed, with a red light warning the minute someone claims “this time it’s different”. Third, boards of financial institutions should take an annual “amnesia check”, which would look at institutions’ risk assessments.
Finally, Radia wants regulators to emphasise supervision rather than regulation, establishing and operating supervisory processes that might mitigate adverse market behaviours. Regulators should be informed and independent from market influence, he said, adding: “People are still in shock and are saying that capitalism is in disarray, but it’s not that. We don’t have enough checks and balances. Our governance system has failed.”
www.efinancialnews.com/story/2012-06-18/learn-to-remember-past-errors
