Financial Education

An investment policy statement (IPS) summarizes a client’s circumstances, objectives, and constraints and outlines policies to accommodate them. It is a document of understanding that can help protect both the client and the adviser.

For clients, developing an IPS can be an educational process that results in greater understanding of the investment process and less reliance on blind faith in an adviser. If a second opinion or change in advisers becomes necessary, the document can help the new adviser appreciate the situation.

For an adviser, having the IPS creates a framework for decisions that can be referred to when particular decisions are questioned.

At the CFA Intstitute Efficient Market and Behavioral Finance conference in June 2007, Legg Mason’s Michael Mauboussin suggested that both market efficiency and behavioral anomalies could be explained by viewing the market as a complex adaptive system.

Under this model the only conditions required are that investors have diverse opinions, that there is an aggregation mechanism to bring information together, and that there are incentives for being right and penalties for being wrong.

The model explains breakdowns in market efficiency (bubbles and busts) as violations of one or more of the conditions. The most likely violation is diversity of opinion, and the occasional herding tendency of investors. It can also occur on a smaller scale when short-term noise is interpreted incorrectly as signal.

Investors can be categorized (on an ad-hoc basis or by the responses to a questionnaire) into one of four categories: methodical, cautious, individualist and spontaneous.

Methodical investors rely on hard facts. They tend to be more conservative, and less emotionally attached to their investments. They are more risk averse and make decisions based on thinking.
Cautious investors are loss averse, and may miss opportunities due to indecision and overanalysis. Although uncomfortable making decisions, they also tend to be uncomfortable taking advice from others. They are more risk averse and make decisions based on feeling.

Individualist investors are self-assured, and put faith in hard work and insight. They work to gain information from multiple sources, and will take the time to reconcile any differences in information between the sources. They tend to be confident that the results of these efforts will be achieved. They are less risk averse and make decisions based on thinking.

Spontaneous investors are less risk averse and make decisions based on feeling. They tend to be adjusting their portfolios constantly, resulting in overmanaged portfolios with high turnover. Profits are often eroded by trading costs. They tend to be more concerned with missing an opportunity than with risk, and doubt the advice of others even though they may not have expertise themselves.

Behavioral finance suggests that investors are loss averse, hold biased expectations and segregate assets. To accommodate behavior, portfolio construction should allow for both objective and subjective constraints. In addition, an integrated portfolio can be formed from layers of segregated assets.

Loss aversion means investors do not view risk as uncertainty but rather as the potential for gain or loss. Investors tend to place more weight on losses than on gains, and will actually seek risk to avoid a certain loss but avoid risk to achieve a certain gain, even when probabilities favor the opposite course of action.

Biased expectations arise from overconfidence about ones predictions of future outcomes and from overestimating the significance of rare events.

Asset segregation, or mental accounting, tends to consider different assets according to purpose or preference. The interaction between investments is often ignored.

Investors who are presented with annual return data for stocks and bonds tend to adopt more conservative strategies (lower allocation to equities) than those who were presented with longer-term return data (such as 30-year compound returns.) Despite the fact that the planning horizon (i.e. retirement) is better represented by the 30-year return than the 1-year return, investors seem to be more concerned with the potential for a short term loss than in planning for the relevant time horizon and accepting periodic short-term losses. Bernartzi and Thaler (1999) describe this phenomenon as “myopic loss aversion.”

Personality can play an important role in establishing an individual investor’s risk tolerance and return objectives. Psychological profiling can bridge the gap between traditional finance and behavioral finance to place the personality in the context of investment objectives and constraints.Traditional finance seeks objective measures of the investor’s circumstances. It implicitly assumes that investors are:

• Risk averse (less volatility is preferable to more)
• Have rational expectations
• Integrate assets (consider the interaction between investments in a portfolio context.)

Behavioral finance assumes psychology prevents the use of objective measures. It assumes that investors are:

• Loss averse (more concerned about a given level of downside than about the same level of upside)
• Hold biased expectations
• Segregate assets

Understanding how investor psychology can interfere with rational investment planning is important, as it can help the investor avoid uncomfortable circumstances and also help the investor act rationally in response to such situations.

Investors tend to have more regret when they make their own poor decisions than when they act on the advice of others or than when they fail to act. For example, the investor who sells bonds to buy stocks that do poorly will feel worse than the investor who does so on the advice of a financial planner, and will also feel worse than the investor who already owned the stocks and kept them (missing an opportunity to replace them with bonds.)

Because of this phenomenon, many investors reap a sort of psychological call option by having a financial advisor. If the investment is successful, the investor can take credit for making the decision, and if it turns out poorly the investor can blame the advisor. This asymmetrical assignment of favorable and unfavorable outcomes is known as self-attribution bias.

A situational profile attempts to categorize an investor by stage of life and economic circumstance. Although doing so risks oversimplifying complex behavior, a situational profile can be a useful first step in determining the investor’s preferences and attitudes.

A situational profile typically includes a discussion of the sources of wealth, the measure of wealth and the stage of life.

Source of wealth can be important indicators of risk tolerance. Entrepreneurs may be comfortable with business risks but uncomfortable with risks they cannot control. Investors who inherited their wealth, by contrast, may be less experienced with risks and investing in general, and less confident in the ability to recover from setbacks.

Measure of wealth considers net worth. However, different investors may have different perceptions of how wealthy a given amount makes them. Investors who view their portfolios as being small are likely to tolerate less volatility than those who consider the portfolio to be large. The more the portfolio returns cover the investor’s spending needs, the more likely it is to be considered large.

Stage of life also influences attitudes toward investment risk and return.  In theory, the ability to assume risk diminishes with age, while the willingness to accept risk is driven more by cash flow (income less expenses.) Other factors may also have an influence, but investors are generally considered to pass through four life stages:

•  Foundation: investor establishes the base for wealth creation – skills, education, formation of business, etc.
  • Relatively young
  • Long time horizon
  • Above average risk tolerance
  • Need for liquidity may outweigh risk tolerance

  Accumulation: Rising income and wealth

  • Expenses rise during early accumulation phase due to marriage, children, home, etc
  • Expenses fall later in the stage as children leave home, mortgage is paid off
  • Income usually continues to rise, increasing ability to save
  • Increased wealth and still-long time horizon increase risk tolerance

  Maintenance stage (early retirement)

  • Need to maintain lifestyle and financial security
  • Wealth preservation becomes important
  • Shorter time horizon and lack of non-investment income reduces risk tolerance
  • Still need some risky assets to preserve purchasing power

  Distribution: Transferring wealth to others

  • Tax constraints become important
  • Planning for distributions can begin much earlier than distributions take place

The life stages are not necessarily linear. A career change could move the investor backward a stage, while an injury or illness could accelerate an investor’s entry to the maintenance stage.

Arbitrageurs seek to exploit temporary market inefficiencies by buying a security they believe is underpriced and shorting a similar security they believe is overpriced. If the securities are not perfectly matched, the trade faces fundamental risks. But even if the securities are perfectly matched, the trade runs the risk that the inefficiency that produced it in the first place will continue or get worse.

For example, when Palm, Inc. shares were first spun out from 3Com investors were far more enthusiastic about Palm’s future than about 3Com’s. So much so, that Palm rose in value to the point that it was valued higher than 3Com – even though 3Com still owned most of the shares. Arbitrageurs sold Palm and bought 3Com knowing that when the remaining Palm shares were spun out they could replace the shares they had shorted and end up owning “free” 3Com shares.

However, the arbitrageurs (information traders) ran the risk that the investors who created the opportunity (noise traders) would continue to misprice the securities. If they continue to force Palm shares higher relative to 3Com, the arbitrageurs could be forced to cover their short positions early at a loss.

Yogi Berra said it’s tough to make predictions, especially about the future. Since many of the forecasts go wrong, it is not surprising that the forecasters have developed some standard replies. In a 2005 Dresdner Kleinwort research report, James Montier laid out the following popular defenses of flawed forecasts.

The “if only” defense says their forecast would have been correct if the advice or analysis they had provided had been followed. This defense is popular because it cannot be proven wrong since historical events will seldom follow a specific analysis. However, the basis of the original forecast was presumably to predict the likely outcome, not the outcome if a certain set of actions occurs. A conditional forecast should also outline the consequences of conditions varying from those set out.

The “ceteris paribus” defense says something interfered with the original forecast. “They would have gone bankrupt but their competitor bought them out.”

The “I was almost right” defense says the forecast almost happened. This applies primarily to averted catastrophes. “Long-term Capital Management’s collapse almost brought down the entire financial system.” If one was predicting the collapse of the financial system, close doesn’t count.

The “it just hasn’t happened yet” defense says the next hedge fund collapse will be the one that brings down the financial system. Either that, or the one following it.

The “single prediction” defense acknowledges that the conditions of the forecast were met but the prediction was still incorrect. However, forecasts are pointless so don’t hold it against the analysis that led to the forecast.