Sunday, October 3, 2010

Self-awareness is power

Published October 2, 2010, The Business Times
Knowing yourself, your goals, and errors is the first lesson in behavioural finance. By Genevieve Cua

BUY-AND-HOLD investing came in for a hammering with the crisis of 2008, as did diversification. Thanks to deep losses in the recent downturn, more advisers have begun to trade client portfolios more actively at the margins, an exercise called 'tactical' asset allocation - or, to put it more plainly, market timing.

But this practice came in for a beating at a talk earlier this week at the Private Wealth Management Conference organised by the CFA Institute.

In a talk laced with humour, Meir Statman, Glenn Klimek professor of Finance at Santa Clara University, had a very clear message for investors and advisers. Prof Statman's research focuses on behavioural finance.

The first lesson, he says, is to know yourself, your goals, and errors. The second is to assure yourself by knowing not just the science of financial markets and instruments, but also the science of human behaviour.

He likens financial advisers to financial physicians. 'Physicians take care of your health, and financial advisers your wealth and well being . . . Good financial advisers have to listen, empathise, educate. That's a big job.

'In standard finance, investors are rational. In behavioural finance, they are normal. People are not rational, they are normal. Sometimes we are normal smart, sometimes normal stupid. It would be nice if we could increase the ratio of smart to stupid, but we're always people.'

People, he says, have been disappointed by diversification, which failed to provide any cushion from loss at the worst of the crisis. Assets in a portfolio are picked for their low correlations with each other, so that they should not rise or fall in tandem. But in a crisis, correlations among most assets spike.

'Diversification assures you that you won't have all your eggs in the crummiest asset. But it also means you won't have your entire portfolio in the best. But you'd be in between.

'People say I'm disappointed. There must be something better - market timing, tactical asset allocation. It's tempting, but it's the equivalent of jumping from the frying pan into the fire.'

He cites a joint study with Kenneth Fisher, to ascertain if the implementation of PE trading rules work. Between 1871 and 2002, US$1 invested in the stock market grew to about US$67,000 using a buy-and-hold mode. In contrast, a trading rule of investing whenever PEs dropped below 26 times would have netted roughly US$60,000.

If market timing isn't a panacea, why do many people - finance professionals included - believe that it is? A number of human traits can explain this: Overconfidence; 'representative' error which is the human tendency to find patterns where they may not exist. The latter error blurs the line between hindsight and foresight.

Trading, in any case, is a zero sum game, he says. 'If I think the market is too high and I sell, someone else is buying it. There is an idiot in every trade and if you don't know who it is, you're in trouble . . .

'You have to ask yourself: . . . What's my information advantage to give me an edge? In all likelihood it's nothing, you're deluding yourself.'

Investors, he says, can protect themselves by making advisers their allies. 'To advisers, I say make yourself worthy of the designation.

'Knowing that you commit cognitive errors is the first step. The second is to remind yourself. Like me, you probably have problems creating defences.'

Advisers, he says, 'have to continuously be teachers of our clients'. 'You can't say I told you that, that you know fear will cause you to be risk averse. You have to teach them again and again.'

While modern portfolio theory (MPT) is routinely taught in finance schools, it is impractical in practice. MPT has a number of key assumptions - that investors are rational and risk averse; that there are no trading costs, for instance.

It points investors to 'optimal' portfolios which represent a combination of assets that give the maximum return for a given level of risk.

The theory implies just one level of risk tolerance, says Prof Statman. 'But we build portfolios not as a whole, as prescribed by (Harry) Markowitz, but in a pyramid. We buy money market funds for downside protection and stocks and lottery for the upside.'

Together with Hersh Shefrin, Prof Statman published a paper in 2000 on 'behavioural portfolio theory'. It posits that investors have multiple mental accounts, and the resulting portfolio does not coincide with a traditional portfolio based on MPT and an efficient frontier.

The behavioural portfolio basically is a two-level pyramid where the lower layer is designed to avoid poverty, and the higher layer is designed 'for a shot at riches'.

Risk tolerance itself may be linked to culture. Prof Statman has written a paper on this - The Cultures of Risk Tolerance. He finds that people who are more trusting, for instance, are more willing to take risk. Those from countries where incomes are relatively low are more willing to take risk.

In 'collectivistic' societies, where there is a family network and cohesive ties, risk tolerance is also higher. This could be because an extended family provides a downside cushion.

At the other end of the spectrum is the 'individualistic' society where individuals are expected to look after themselves. Singapore and China rank fairly low on the individualistic scale, and the highest ranked are the US and UK.

Prof Statman himself keeps his investments 'very, very simple'. 'What do I do in a crazy market? I invest and close my eyes rather than try to pick out where the mania will go; it's self-defeating.

'It's very hard to explain to clients, but I think the way to do it is to say - here is what we know from science. Here are some studies I can show you about how people try to take advantage of cycles and fail.'

Once you've made the plunge to invest, switch off the noise from news commentators, he says. 'I keep my investments very, very simple, and I think I've done very well. I invest exclusively in index funds and let stuff take its course. I have enough money in my downside protection account to make sure I'm not going to be poor.

'The money in my upside account, I don't do options. The stuff I have in equities, sometimes it goes up and it goes down. I shrug, what can I do?

'If you train yourself to be like that, you will do yourself a great favour. It's hard, (an adviser's) business is transaction oriented, because I'm not going to give you much business. I don't trade. I think (that's) smart behaviour.'

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