Book Review of "Behavioral Investment Management" (2012)

Behavioral Investment Management: An Efficient Alternative to Modern Portfolio Theory by Greg B. Davies and Arnaud De Servigny (McGraw-Hill, 2012)

“People in standard finance are rational. People in behavioral finance are normal.”

Meir Statman, PhD, Santa Clara University

The above quote by Meir Statman captures concisely the thrust of the concepts explored extensively in this new book by Greg Davies and Arnaud De Servigny.  They tackle what is by now a relatively widespread view that modern portfolio theory (MPI) has fundamental flaws when used blindly to build portfolios for individuals.  However, rather than throwing the baby out with the bath water, they zero in with quantitative precision on the aspects of this developed theory that they counsel should be modified to reflect the fundamental truth of how humans process concepts and make decisions.   

You should note that Greg is Global Head of both Behavioral and Quantitative Investment Philosophy at Barclays Wealth.  Arnaud is the Global Head of Discretionary Portfolio Management and Investment Strategy at Deutsche Bank Private Wealth Management and Adjunct Professor of Finance at Imperial College Business School in London.  Given their backgrounds, both behavioral and statistical topics are explored in this book with extensive use of quantitative methods (think lots of formulas).  Be ready to don your math hat on when reading it. 

The first 4 chapters review the concepts of modern portfolio theory (MPT), efficient market hypothesis (EMH), and expected utility theory (EUT).  Additionally, they provide a detailed expose on the flaws when using them for individual investor portfolio optimization.  They indicate that defining an optimum portfolio for an individual requires the investor -

Have a clear notion of their preferences for risk and return; and
Make assessments of expected risk and return of the investment assets reasonably accurately.

We may all agree, but finding clarity and agreement with clients on these two points is inordinately challenging.

The authors acknowledge that individuals have to make two decisions.  First, what portion of wealth should be consumed in the next period versus saved to fund future needs.  Second, how the savings should be optimally invested.  The book focuses on the second question, but (our opinion) working through the process to identify answers to the first can be remarkably helpful in diagnosing some of the biases and normal emotional pitfalls addressed later in the book.

A few other insightful observations they suggest to “behavioralize” finance are:

·         Time horizons are interpreted by people as emotional time horizons, not practical ones.

·         Many people focus inordinately on a single investment decision versus its impact on the overall portfolio.

·         Citing cumulative prospect theory[1], they explain that people focus inordinately on changes in wealth levels from current values versus their overall level of wealth (which should not be used to guide investment decisions).

·         The explanation of the need to incorporate two mental systems (sometimes referred to as the preference for deliberative versus intuitive decision making process, or system 1 and system 2 thinking), they explain simply as the  long term “rational” self and it’s short term irrational brother.

A few practical suggestions are provided aimed at offsetting these biases to mitigate reactivity:

·         Express figures in annual or five year terms – in order to lengthen the time horizon for decision framing.

·         Reduce the frequency of monitoring performance.

·         Engage a process where investors pre-commit to a planned investment decision that will be executed automatically.

Chapter Five (which included contributions by Shweta Agarwal, a PhD student at the London School of Economics) contains several key concepts in the formulation of amendments to traditional asset allocation work.  Specifically, the more tailored inclusion of risk in portfolio construction.  The key change is to adjust the typical asset categorical risk factor (i.e., variance) to include an assessment of how much return (in excess of the risk free rate) it would take to justify an investment.  This adaptive measure is termed behavioral standard deviation.  The examples illustrate the portfolio construction decisions for nine asset categories of three sample individuals based on their personalized behavioral standard deviation (high risk tolerance, moderate or “normal”, and high anxiety/low risk tolerance). 

The implication is that in a world of investment possibilities that include a myriad of non-normal performance possibilities (think skewness and kurtosis), we can and should identify an efficient frontier to maximize returns for each individual’s specific level of behavioral risk.

Chapters 6 and 7 provide insights on how to view the process of evaluating market dynamics and portfolio construction through the lens of behavioral implications.  One interesting observation is that their data support the concept of monthly rebalancing of portfolios to align with strategic policy allocations.  Additionally, the concept of more active and frequent assessment of expected returns and reshaping the optimized portfolio are inherent in their approach.

Chapter 8 tackles what are perhaps two most impactful set of issues in dealing with individual investors; namely, typical errors or biases, and inordinate dependence on unstable short-term preferences.  The authors propose that both be removed from the process of portfolio optimization.  While you may or may not agree with this conclusion, it is clear that addressing them is highly challenging.  Our sense is that an emerging number of researchers believe that biases simply cannot be eliminated in individuals, but only recognized and marginalized when it is clear that they adversely impact the efficiency and effectiveness of the decision making process.

Strategies that they propose for addressing these issues are:

·         Align decision frames with long-term objectives (to enhance the impact of a more realistic/longer time horizon).

·         “Purchase emotional comfort”.  The concept is that we might develop a range of proscriptive actions as salve to alleviate our burning emotions.  The idea includes identifying costs relative to objectives.  (i.e., maintaining a large cash reserve for peace of mind is balanced against the foregone returns in deciding how much “medicine” to take)

·         Increase allocation to low-anxiety investments and engage downside protection strategies.  All carry some costs, but may provide sufficient benefit to remove undue emotional influence on decisions.  Specifically consider:

o    Option strategies to eliminate far-left tail exposure.

o    Funds that have a longer time horizon or are less frequently marked-to-market for valuations.

o    Investments with narrow downside exposure to monthly losses.

o    Funds that bundle a wide range of investments in their reporting (aggregation = less volatility).

o    Dollar cost averaging for investments (particularly of value in connection with a large liquidity event).

o    Avoiding information or media that is too focused on short-term or detailed asset price movements.

o    Engaging a sign off process for big investment decisions that automatically incorporate deliberative thinking (perhaps by independent advisors).  Alternatively, require a cooling off period prior to executing a decision.

The final chapter in their book includes ideas that from their perspective would help enhance the state of the wealth management industry by incorporating their ideas in tailoring the process more adroitly to client needs.  Specifics are:

·         Advisors are (typically) risk managers for their clients.  This role requires more substantive attention to focus on appropriate tools to profile and diagnose client’s individual risk preferences and incorporate them into their consulting support.

·         In this role, risks to be addressed are structural (markets/investment structures), emotional, and liquidity.  Specifically in a world in which our demographics are shifting to enhanced concerns about managing living expenses over remaining lifetimes, this is an area of growing importance.

·         Move from static asset allocation methods to those that are more dynamic.  They note that the evaluation horizon for wealthy people is moving toward a 2 to 3 year horizon versus 5 to 10 as in the past.  

·         They foresee that firms adapting a more behaviorally focused approach to their client service process will result in significant competitive advantage.

While this book is not an easy read, it is packed with practical insights of great value.  We believe it clearly delineates the pathway that future research and professionals should pursue.  Also, it is a must read for advisors who recognize the value of incorporating a more substantive application of behavioral techniques in their client serving process. 

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[1] Kahneman and Tversky (1979), Tversky and Kahneman (1992)

Hope you enjoy the book!

Mark the Advisor

Middle Eastern Paranoia, Oil, and the Psychology of Playing Chicken

When I was a boy in west Texas the neighborhood children enjoyed playing chicken, usually with speeding shopping carts.  Two children were pilots and two children were bombs.  The pilots dutifully ran their bombs up to full speed, released them, and … CRASH.  Ideally your shopping cart remained standing after the collision, in which case you won.  Fortunately, two shopping carts crashing sounds much more painful than it actually was.  But this newsletter isn’t about the antics of bored suburban kids. This month we look at a much more deadly game of chicken between Iran and Israel (and by proxy, the U.S.A.). Mirroring the escalating tensions, oil prices are up over 10% in the past five weeks.  Higher oil and gasoline prices are already impairing our economic recovery. This newsletter will examine Behavioral Game Theory as it applies to Iran and Israel.  What is the best strategy to deter a foe who may be crazy, short of war?  We will then look at the current sentiment snapshot of news and social media as it relates to Oil, Iran and Israel, which reveals some surprises about global mood and where the fear is this week.  The psychology behind Oil’s recent price rise reveals whether the rally is sustainable (hint:  fear is rarely sustainable in the short-term). In addition to our usual haunts of New York and Los Angeles, we will be speaking in San Antonio, western Pennsylvania, a CFA webinar, and San Francisco in March – we’re look forward to catching up with our friends in those cities!

Cooler Minds:  Fighting Fear with Facts

In evaluating any tense situation, the first priority is to get grounded in the facts.  Iran now has the capability to create weapons-grade uranium inside a bomb-proof mountain near Qom.  (U.S. experts do not believe a weapon has yet been assembled nor is within a year of being so).  Iran provides weapons and training to Hezbollah, who battled Israel in southern Lebanon in 2006 (with surprising success).  As part of sanctions, Europe and the United States have stopped taking delivery of Iranian crude oil and have frozen Iranian central bank financial transactions.  From Israel’s side it is clear that a covert process of sabotage and assassinations is occurring against Iran’s nuclear enrichment program. As far as rhetoric, there is more to consider like the public murals depicting bombing the United States.  (but recall, statements are not facts, and are typically negotiating tactics or posturing for a secondary gain – think North Korea).  Various members of Iran’s leadership have threatened to “wipe Israel off the map,” sponsor a second Holocaust, and make other unconscionably inflammatory statements.  The Iranian leadership boasts that in response to a military strike against it it will close the strait of Hormuz to shipping (e.g., oil) traffic. Israeli government statements indicate that for existential reasons (and I'm not talking about Sartre) Israel won’t allow Iran to possess nuclear weapons.  Israelis also indicate there is 3-4 months before Iran’s nuclear development will be too far along to stop with a military strike. Just Because You're Paranoid Doesn't Mean They Aren't After You Now for our specialty - the psychological context.  Keep in mind that excessive fear is paranoia, and paranoia is one of the most powerful types of fears, bolstered by one’s own feeling of isolation and often leading to self-destruction (e.g., Othello).  Paranoia is present to varying degrees in most people – given that 15% of prehistoric humans met a violent death at the hands of another human, paranoia was an adaptive trait on an individual level.  As strange as it may sound, through the emotional defense mechanism of projective identification the paranoid often induce others to treat them harshly or suspiciously.  Yet on a population level, group paranoia often leads to irrationality and atrocities against the feared others through this same process of projective identification. The Iranian revolution of 1979 overthrew a British and American “stooge” – a monarchy placed in power by the CIA and MI6 in 1953 by overthrowing a democratically elected Iranian Prime Minister.  Iranians rightfully see themselves as past victims of American meddling, and the regime does not trust the U.S., Israel, or Britain.  Iranian propagandists go so far as to portray Israelis, British, and Americans as sub-human, referring to them as “dogs” and “infidels.”  Is the Iranian leadership paranoid about U.S. and Israeli intentions?  From our perspective, of course.  Might their paranoia drive them to develop the very nuclear bomb we are paranoid about them possessing?  Yes, definitely, wouldn’t you want maximum deterrence against a proven enemy too? See the image above of a mural from outside the former American embassy in Tehran.  One of the requirements in paranoid terrorist psychology is to dehumanize the opponent, so normal human empathy is turned off.  Predictor of action:  If you don’t see another as human, you can hurt them with no sense of remorse (in fact, you feel righteous to do so because you are protecting your group). Yet Israelis see an Iranian nuclear weapon as an existential threat (and the Iranian leadership has said as much).  Given Israel’s history of near-annihilation on multiple occasions (not irrational paranoia), the military is not relaxed about this threat.  Predictor of action:  When backed into a corner, no option is off the table. The Game Theory Behind “Playing Chicken:”  Throwing Out the Steering Wheel In a startling twist of fate, the father of Game Theory involving multiple equilibria in noncooperative games was John Nash, subject of the Academy Award-winning move A Beautiful Mind.  Nash is a mathematical genius who won the 1994 Nobel Prize in Economics for his contributions to the field.  However, in his early 20s he developed paranoid schizophrenia and spent many years in institutions.  During the U.S. debt ceiling stalement in July 2011, University of Washington Professor David P. Barash wrote an op-ed in the New York Times explaining the game theory behind the show-down over raising the debt ceiling.  Many of his examples are illustrative of what the West is facing with Iran. Dr, Barash explains that by playing chicken (as the Tea-partiers appeared to be doing over the debt ceiling talks) low-power players can extract additional concessions due to their “hardliner” stance.  As he puts it, “The trick to winning is for one player to convince the other that under no circumstance will he or she veer off course.”  Dr. Barash continues, “Another tactic, favored by the strategist Herman Kahn, is to “throw out the steering wheel,” to demonstrate that you are locked into a certain path and can’t swerve. “ In such cases of playing chicken, it is best to convince your opponent that either 1) you have no alternative course of action and so CANNOT compromise (“my constituents won’t let me back down”), or 2) you are stone-cold crazy and could care less about the consequences to yourself (“I will take you down with me if that’s how it has to be!”).  Both of these strategies increase the negotiating power of a lesser player, but they also presume a rational analysis of the situation by that player.  Sometimes your opponent truly is suicide-bomber-crazy, and you will always lose when playing chicken with such an opponent (as will they, but they won’t care).  The strategy Dr. Barash concludes with is the following:  “In either case, whether you’re confronting a rogue elephant or a rogue nuclear state, the advice is the same: stop playing the game. Avoid the elephant or shoot it; politically isolate the rogue state or use military force to disarm it.” So how do you know whether your opponent is strategically crazy as in the first two cases or crazy-crazy like a suicide bomber? (See Dr. Barash’s article or book to learn more).  In the case of Iran, the key question is, is the leadership acting strategically to increase their bargaining power, increase their esteem among their own people, and perhaps even earn the international perks and payoffs that North Korea (food aid, energy shipments) and Pakistan (military “aid” and free cash) have earned?  This seems plausible enough, but before moving on, we need to determine if the leadership of Iran is truly crazy. Aside from a perhaps justified paranoia about foreign invasion, Ayatollah Khamenei and the Iranian leadership has excellent hygiene and don’t apparently speak to themselves in public.  However, the leadership is generally comprised of lifelong religious scholars, and given the sometimes thin psychic line between communicating with Angels and believing the CIA is following you, this might actually be worrisome.  But wait, the CIA is following them.  In any case, what evidence is there for leadership insanity?  None of which I am aware, although very clever people such as Stanford’s Robert Sapolsky have noted fascinating parallels. So the first preferred strategy when dealing with such an opponent is to politically and economically isolate the country (done).  Given the history of paranoia and poor relations between Iran and the West, and the absence of a legitimate political alternative to Ayatollah Khamenei and the Grand Council, it’s likely that isolation will not bring down the Iranian government.   If isolation doesn’t work – and how long will we wait? - then either ignoring Iran (e.g., North Korea and Cuba) or a military assault (nuclear sites bombed by Israel in Iraq and Syria) is likely.  To prepare for a military assault, bolder internal attacks and discord-sowing are already occurring.  Then the choice becomes to either 1) Ignore Iran’s nuclear program and hope for a Cold War-style stalemate, or 2) execute a series of focused military attacks to further delay the program.  Given Israel’s existential angst and previous history of striking Syria and Iraq, military assault appears most likely.  The only question is when. What Do The Markets Think? The spot Oil price is a good proxy for potential conflict between the Israel and Iran, as the Strait of Hormuz and oil facilities will presumably be threatened for some length of time.  Since late January we’ve seen not only a climb in the oil price (and the stocks of energy companies), but also a divergence between the amount of fear expressed by energy stock investors versus S&P 500 stock investors.  In this case, fear is good for the oil price and the profits of most energy companies. We also see high the levels of fear and pessimism in country-related messages in social and news media expressed about Iran and Israel.  One difference we see in social and news media is a high levels of predictions of a higher oil price in social media, but only neutral predictions in the news.  When higher prices are forecasted in conjunction with high fear, we usually see a price slide over a few weeks (although, the fear and price may rise again as the Israelis make more preparations for an assault).  By the way, we’re also seeing high fear from investors in Copper, but in the case of copper, there is a good fundamental reason for fear, as China has ratcheted down growth projections.  In such a case of fear with a rational basis, the price tends to continue a longer-term decline as the market gradually readjusts its expectations. Extreme Event Modeling Remember, the only way to prevent mistakes driven by fear is to be prepared.  Run forward what would happen to your portfolio in case of an escalating war in the Middle East and a disruption to oil supplies (paired with a slowdown in the economy).  If you’re a financial advisor it’s worth preparing what you’ll say to clients when they angrily ask, “why are we still in equities, everyone saw this attack coming?!”  (Ask us for tips about communicating with clients).  Energy traders would do well to stress test in case of an oil shock, including what if the limited war grows to include missles back and forth from Saudi to Iran and a broader Sunni-Shia conflict.  And keep in mind that after the initial shock, war often leads to stock price appreciation as government spending spikes and the defense industry revs up.  Discretionary managers may benefit from Trading Coach Richard Friesen’s Extreme Event Exercise – reply to this email with “Extreme” in the subject line to learn more. But all that being said, we truly hope for peace.  Just remember to be prepared for the worst case (write down your plan), so you can go to sleep with one less potential train-wreck to ponder – we’ve had enough disasters to think about these past four years. Talks in March and April We have speaking and training availability for your firm or organization in late April.  Please contact Dr. Peterson or Dr. Murtha for more information. Happy Investing! Richard L. Peterson, M.D. and The MarketPsych Team