|
Dubai: A study of economic Noble Prize winners is one way of looking into future trends in wealth management. In the early 1990s Markowitz and his school of "Modern Portfolio" thinkers did to portfolio planning what the impressionists did to art: changed it forever.
Then came Kahneman and Tversky whose prize was won around a decade later. Their "school" of thought is increasingly dominating the delivery of portfolios. His is the school that sought to demonstrate how people react to losses and gains within their portfolio. Get this right, of course, and the ability to manage investor expectations - and therefore keep them as clients - would be significantly enhanced.
So over to Jennifer Bovard, an organisational psychologist who also advises investment firms on how to understand investor behaviour. Given that equity markets are going nowhere, commodity markets are going everywhere, and bond markets are perplexed, perhaps a session or two with the psychologist might help. The following form my notes of a "session" with the doc. This week her focus is on the background to decision making. Next week, a look at some of the behavioural "bias" in investment decision making.
In management, decisions should be based on empirical research and data, rather than relying solely on gut instinct. And, in business, there are no simplistic solutions to organisational issues, such as 'Five Steps to Good Leadership' or 'Six Ways to Motivate Staff', because the evidence suggests the phenomena are complex, difficult to measure, and require depth.
Sound research
Psychologists in organisations apply their knowledge and skills based on sound research and proven methods. Similarly, the relatively new field of behavioural finance is based on sound research.
It examines how psychology influences financial decisions and, unfortunately, the evidence suggests that our psychology strongly influences these decisions.
The history of behavioural finance is rooted in decision theory, and traces back to 300 BC through the work of the Greek philosopher Aristotle. He advocated that decision making is a rational, scientific process, involving careful computation of a universal set of options. There will always be a place for rational processing, but the evidence suggests that it doesn't always happen.
It is interesting to note that classical decision theory remained popular for 500 years and formed the basis of many economic theories.
Even in recent decades some management textbooks have proposed different forms of prescriptive decision making, such as decision trees and critical path methods, which also emphasise a logical framework and an emphasis on rationality.
Some theorists treat these approaches unfavourably for the same reasons that classical decision making is losing popularity - because we often lack the information we need on the alternatives, and individuals may lack the capacity to store and process all the relevant information
Classical thinking was challenged in 1957 by Herbert Simon, who went on to win a Nobel Prize for Economics in 1978. In his work on Bounded Rationality, Simon found that in the real world people make decisions by simpler models, without integrating the complexity of the situation. He also found that in practical reality people often opt for the first satisfactory choice, known as 'Satisficing'.
Human rationality
Amos Tversky and Daniel Kahneman, both fellows at the Centre for Advanced Studies in the Behavioural Sciences at Stanford University in the 1970s, found more evidence of the limitations of human rationality. They discovered that excessive information can both overload and delay us, leading us to take shortcuts in making judgments, which often lead to human error.
We are genetically hard wired to simplify and interpret our environment so that it is predictable. (It can be just a little overwhelming to think that elements of our behaviour are driven by non conscious, evolutionary hardwiring. But mating behaviour in humans in one such example.)
Tversky and Kahneman's research focused on cognitive illusion, which recognises that the brain uses filters to interpret and make sense of what it sees. However, what we interpret may be inaccurate. Optical illusions are a good example of this - parallel lines, for example, may visually appear to bend when confounded by a network of lines which emanate out from the centre of the image.
In addition, these filters may be clouded by our emotions, experiences, upbringing and individual differences, so that each of us might interpret the same stimulus differently. A lecturer was a little concerned when one of her students saw his mother-in-law in the image below!
Each of us might interpret the same stimulus differently
Much of this research into cognitive and motivational bias has been adapted by psychologists and HR professionals in training managers to minimise their own personal biases and prejudices in assessment areas, such as interviews and appraisal meetings. Many of these biases are non-conscious, or become so after time through an unconscious learning and reinforcement process.
Taking this research one step further into the ground-breaking domain of behavioural finance, Tversky and Kahneman went on to win a Nobel prize in Economics in 2003 for their work. While the finance industry has evolved based on rational principles, they found that the investment field was fraught with human error due to cognitive and motivational bias.
Decision and memory research also has wide applications to investing. For example, research on long-term memory and problem solving shows that experts solve problems differently that novices do.
Take a chess player, for example. A master chess player can look at a configuration of over 20 pieces in just 5 seconds and reproduce it perfectly, while a novice can only reproduce 7, plus or minus 2. This is called chunking, and it explains how a master chess player can encode in memory and retrieve up to 50,000 configurations.
This suggests that novice investors have to be aware of their limitations, and may well refer to experts in the field with proven capabilities.
Next week we look at some examples of behavioural bias in investing.
The writer is chairman of Mondial Financial Partners.
|
