Managing Behavioral Responses to Investment Downturns

Transcription

1 IPI Winter Forum in San Francisco February 9, 2010 Managing Behavioral Responses to Investment Downturns Jim Foster, Managing Director Pittsburgh, PA Houston, TX Portland, OR Copyright 2010 Greycourt & Company, Inc. All rights reserved. 2/4/20101

2 Agenda Optimizing Wealth Destruction Behaviors in Crisis Situations Humans are Hard Wired for Mistakes Reducing Vulnerability What is The Right Portfolio, Alex? 2 What is the greatest risk to a family s wealth and future purchasing power when a crisis hits the markets? Why do families reflexively destroy capital by immortalizing capital losses and then allowing their risk taking abilities to atrophy? Destruction of wealth seems hardwired into the investment decision making DNA of many investors when severe and protracted downturns strike their portfolios. In this session, we will discuss the Whys and the How Tos of extreme event decision making for families and their advisors as we explore what it means to say that the greatest risk to family wealth is owning the wrong portfolio! 2

3 Optimizing Wealth Destruction Invest in an overly risky portfolio Liquidate risky assets at the peak of a crisis and then again at or near the market low Stay on the sidelines when risky assets subsequently rebound 3 Destruction of wealth does seem hard wired into the investment decision making DNA of many investors when severe and protracted downturns strike their portfolios. For a variety of reasons, investors with overly risky portfolios proceed through a sequence of overconfidence and herding to anxiety and then full blown panic as they race to immortalize capital loss, often from the peak of a crisis until its subsequent low point. Compounding that first round of wealth destruction is a period of risk atrophy and inaction during which investors watch the portfolios they used to own rebound significantly. In psychological terms, their behaviors center ultimately on flight and freeze, while the financial impact of this loss and inaction cycle is a substantial reduction in wealth and relative purchasing power. 3

4 Bad Choices Entail Bad Consequences The issue in crises and extreme events is making wise choices Traditional decision approaches assume investors can subjectively assess the impact and likelihood of choices and rank them accordingly In fact, emotional reactions in crisis periods often conflict with these rational assessments and drive destructive behaviors 4 Real outcomes result from choices taken during crises and extreme events. Real family wealth is destroyed and purchasing power is impaired. As a result, we know that bad choices do entail bad consequences. Normative remedies are needed and must derive from a clear understanding of how judgments are formed and how decisions are actually made. The traditional approach to investment decision making involves a rational calculus that is often characterized as cognitive and consequentialist. Consequentialist implies that decisions are based on an assessment of the consequences of possible outcomes, including the impact of anticipated emotions in the future. What the traditional approach fails to consider, however, are the immediate and often visceral feelings associated with a decision itself. Because of this omission, traditional decision making is also referred to as cognitive. 4

5 Reality is merely an illusion, albeit a very persistent one. Albert Einstein Consequence Based Anticipated Outcomes (Including Anticipated Emotions) Cognitive Evaluation Subjective Probabilities Behavior Outcomes (Including Emotions) Feelings Feelings Based Other Factors: e.g., Vividness, Immediacy, and Background Mood 5 Based on what we witness as investors melt down in crisis periods, it is reasonable to conclude that emotions inform decision making and that immediate emotional responses to risky decision situations often diverge from cognitive evaluations. (Loewenstein). In other words, emotion driven behaviors displace Homo economicus when push comes to shove in real markets. Understanding the dynamic interplay of cognitive and emotional factors, and in particular distinguishing between anticipated emotions and anticipatory emotions, is critical to understanding and managing the role of feelings on risk assessment and decision making. 5

6 Wow! The better we do, the smarter I am! What a deal! In five years this house will be worth a fortune! Cisco is the greatest dot com. You should get in on the action 6 To better understand practical wealth destruction, it s important to retrace the steps that often lead to panicked selling. In the pre crisis phase, we encounter surging markets and an over confident investor in the company of a growing and influential group of similarly over confident investors. The cartoons (Scientific American) depict two important cognitive illusions that powerfully influence consequentialist and feelings based inputs during this phase. Excessive conviction follows from a propensity to overrate our skill. Like the children in Lake Wobegone, we sincerely believe we are always above average and selectively emphasize information that confirms our inflated view when forming judgments and views (confirmation bias). As we and others converge to similarly satisfying conclusions, a herd forms that negatively reinforces our tendency to disproportionately weight recent positive information in projecting future outcomes (availability bias). Together, these illusions color our analysis and emotions. 6

7 Everything that rises must converge. Flannery O Connor 7 At some point in the progress of bubbles, prices reach unsustainable levels and cracks appear in the positive data stream. Availability bias flips over as immediate data begins to point to falling prices and the race is on. From a decision perspective, these early fissures induce anxiety as our investor begins to feel vulnerable to the environment and to others in the herd. Fear of loss of control and a sense of being overwhelmed makes us anxious. The importance of wealth to most investors only serves to amplify this anxiety until the sustained sense of vulnerability becomes acute, danger seems imminent, and anxiety transitions to full fledged panic. Triggered by a unity of correlation across risky assets, our seemingly entrapped investor shouts SELL, SELL. 7

8 Reducing Vulnerability Partition strategies into pre crisis, crisis, and post crisis periods Engage in purposeful study, introspection, and historical simulation Clarify roles and responsibilities particularly with non family advisors through policy statements and operating manuals Exploit behavioral opportunities such as framing, anchoring, and counterfactual thinking to force skepticism and self awareness 8 Given the cognitive and behavioral insights discussed so far, we know that investors are vulnerable to a wide range of challenges in virtually every aspect of investment decision making. Accordingly, it is important that investors and their advisors implement effective programs for extreme event preparation, response, and recovery. Any such program must engage investors and advisors in regular, ongoing, and purposeful study of the cognitiveand feelings based patterns involved in prior crises and must tailor and exploit behavioral opportunities such as framing, anchoring, and counterfactual thinking to force skepticism and self awareness. It must also formalize regular actions by implementing specific policies, procedures, and checklists that anticipate and mitigate the panic that builds through a full crisis cycle. 8

9 Always swim with a buddy! Identify someone with investing acumen to regularly play the devil s advocate and empirically test your convictions and feelings Develop checklists with respect to all of the components described in the model of decision making shown on slide five Develop and regularly apply specific cognitive investment methods including long term multi cycle relative value analysis of asset classes 9 The Boy Scouts have it right about being prepared always swim with a buddy who watches your back and holds you to account for the behavioral and cognitive factors at play in your investment thinking and decision making. The great enemy of successful investing especially crisis investing is a reliance on intuition and feelings that are not validated by rigorous analysis and empirical testing. Without an honest and persistent devil s advocate, we inevitably rely on heuristics that worked well when we were attacked by now extinct wild beasts but are inadequate when we are making judgments in highly probabilistic and competitive markets subject to animal spirits! 9

10 Final Jeopardy! The Final Jeopardy Category is Egregious Investing Errors Owning this maximizes the likelihood of avoiding wealth destruction during a severe market crisis My Final Jeopardy Wager is My Family s Wealth What is The Right Portfolio, Alex? That is the correct answer! 10 To manage through crisis periods and extreme events, we propose designing and implementing programs that function in some sense as a vaccine or antidote to the many behavioral and cognitive challenges bestowed on us by Mother Nature and a capitalist political economy. Having such a program is necessary to mitigate the risk of panic and wealth destruction, but it is insufficient. The true test of effective extreme event preparation is choosing The Right Portfolio well before any crisis or extreme event occurs. To do that requires understanding the trigger that transitions investors from anxiety to panic. That trigger is the unity of correlations that occurs swiftly and completely when all risky assets plummet in a market crash. The perception that the market for risky assets, and hence all family wealth, is going to zero ignites panic. The remedy that forestalls a shift in the emotional balance of power, however, is owning enough of the Flight to Quality Asset in the family s portfolio. How much is entirely subjective in that there needs to be enough impact on portfolio performance that the investor perceives the existence and support of this negatively correlated asset in the emotional battle against panic that is measured by the family P&L. A positive position with imperceptible performance impact won t get the job done. Heuristics for setting the amount will be discussed during the session. 10

11 References and Interesting Sources Jaffee, D., Markets Under Stress: The Case of Extreme Event Insurance, in Arnott, R., Greenwald, B., Kanbur, R., & Nalebuff, B. editors, Economics for an Imperfect World: Essays in Honor of Joseph E. Stiglitz, MIT Press (2003). Kobbeltvedt, T., & Wolff, K. (2009). The Risk as feelings hypothesis in a Theory of planned behaviour perspective. Judgment and Decision Making, Vol. 4, No. 7, December 2009, pp Loewenstein, G., Weber, E. U., Hsee, C. K., & Welch, N. (2001). Risk as Feelings. Psychological Bulletin, 127(2), pp McElroy, T., & Dowd, K. (2007). Susceptibility to anchoring effects: How openness to experience influences responses to anchoring cues. Judgment and Decision Making, Vol. 2, No. 1, February 2007, pp Plous, S. (1989). Thinking the unthinkable: The effects of anchoring on likelihood estimates of nuclear war. Journal of Applied Social Psychology, 19, pp Roese, N. J., (1997). Counterfactual Thinking. Psychological Bulletin, Vol. 121, No. 1, pp Scientific American, The Science of Bubbles & Busts, July 2009, pp Slovic, P., Finucane, M. L., Peters, E., & MacGregor, D. G. (2004). Risk as analysis and risk as feelings: Some thoughts about affect, reason, risk, and rationality. Risk Analysis, 24(2), pp Stewart, T. R., & Bostrom, A. (2002). Extreme Event Decision Making Workshop Report. Center for Policy Research, Rockefeller College of Public Affairs and Policy University at Albany, pp

12 Jim Foster Managing Director Greycourt & Co., Inc. 607 College Avenue Pittsburgh, PA Pittsburgh, PA Houston, TX Portland, OR Copyright 2010 Greycourt& Company, Inc. All rights reserved. 2/4/ Jim Foster is a Managing Director of Greycourt & Co., Inc. Prior to joining Greycourt, he was an Executive Vice President and Head of Distribution for Schroder Investment Management North America in New York. Before that, he was a Senior Vice President with Mellon Financial Corporation working across institutional investment management and consulting. Prior to joining Mellon, he was a Vice President with J.P. Morgan where he helped establish the mortgage backed securities department and traded and made markets in mortgage backed securities. While at Morgan, he worked in Global Derivatives in the Equity Derivatives Group and was responsible for private structures created primarily for U.S. pension accounts and investment managers. He also taught fixed income securities markets, valuation, and portfolio management techniques for several years as an Adjunct Assistant Professor of Finance in the Stern School of Business at New York University. Mr. Foster is a graduate of the University of Michigan and Carnegie Mellon University and currently chairs the Board of Visitors for the University of Michigan s Institute for the Humanities.