Consultiva Internacional, Inc.Third Annual Investment Management Conference

November 15, 2002

The Human Element…

How it affects Individual and Institutional Investing Decisions

Javier Rubio, CFAMario Iturrino

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The Human ElementThe Human Element in: in: 1) Individual Investors

2) Institutional Investors 3) Investment Committees

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1) The Human Element in Individual Investors:

The following three elements have a significant effect on individual decision making process

Preferences (Risk Profiles) Over-confidence Regret

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a) Risk Profiles (Loss Aversion) 1) You Receive $1000

2) Now Choose Between

a) A sure gain of $500 b) A 50% chance to win $1000 and 50% chance of

$0

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1) You Receive $2000

2) Now Choose Between

a) A sure loss of $500 b) A 50% chance of no loss and 50% to lose

$1000

a) Risk Profiles (Loss Aversion)

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a) Loss Aversion Gamblers’ Results:

A) 84% Choose the Sure Thing: $1000 + $500 = $1500, zero variance

B) 69% Choose to Gamble: $2000 less either $0 or $1000 = $2000

or $1000

Conclusions: People hate losses more than they like

gains

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a) Loss Aversion Utility Function

Paul Samuelson’s wager:

Coin toss: win $200, lose $100 Probability: (.5 x 200) + (.5 x –100) = $50

Colleague’s response: “no”

Myopic Loss Aversion and the Equity Premium Puzzle, Shlomo Benartzi and Richard Taylor, Quarterly Journal of Economics 1998

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b) Over-confidence…

“Some people will have accidents,

but not us.” 90% of Drivers in Sweden “Above Average” Some people will have stupid kids, “but ours will be gifted.”

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b) Over-confidence “What is the Expected Return of Stocks?”

(High expected returns follow high realized returns)

Sept. 1999

Sept. 2001

15% 40%39.8%

-24.4%

13.2%6.3%Expected

Return on Market

S&P Return during the

preceding 12 months

Source: Gallup

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b) Over-confidence

“What is the Expected Return of YOUR Stocks?” (I will do better than the market)

Sept. 1999

Sept. 2001

14.9%

13.2% 6.3

%

7.9%

Own portfolio

Stock Market

Source: Gallup

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b) Over-confidence “Is the market overvalued?”An overvalued market offers higher expected returns….

Sept. 1999

Sept. 2001

50 15%49

2713.2%

6.3%

Expected Return on Market

Overvalued

Source: Gallup

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b) Over-confidence “Is this a good time to invest?”

Yes …but the market is overvalued

Sept. 1999

Sept. 2001

49%

27%

72%53%

Overvalued

Good Time to Invest

Source: Gallup

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c) Regret

Why didn’t I sell when the NASDAQ was at 5,000?

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What do investors want?

Investors are:

Rational -consider portfolios as a whole:

Standard (mean-variance) Portfolio

Investors are:

Emotional

- risk-averse AND risk-seeking

-portfolios as mental accounts:

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2) The Human Element in Institutional Investors:

Overconfidence Pattern Recognition

Following the CrowdStyle Traps

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a) Over-confidence:a) Over-confidence:

Pattern RecognitionPattern Recognition

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a) Over-confidence:a) Over-confidence: Pattern RecognitionPattern Recognition

Touch a button, S or B

You win (money or food) if the choice is right.

S B

a) Over-confidence:er-confidence:

Pattern RecognitionPattern Recognition

Human vs Rat Intelligence:

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0%

20%

40%

60%

80%

100%

1 2 3 4 5

Men

Rats

Time

Touching Button S

B

S 4/5 chance of winning

1/5 chance of winning

a) Over-confidence:er-confidence:

Pattern RecognitionPattern Recognition

Never

4/5

AlwaysRats

Humans

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a) Overconfidence Barron’s Annual Roundtable*

Wall Street Super-stars24 years, 1751 recommendations1599 buys, 152 sellsBuys

+1.9% Before Publication 0.0% After Publication

Sells –1.2% Before Publication -8.1% After Publication

Journal of Finance, Sept 1995, H. Desai and P.C. Jain

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b) Traps in Active ManagementTraps of Active Management

-1.2

0

1.2

0

Hate

Curiousity

Interest

Concern

Conviction

Love

Panic

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b) Other Traps

Are We too Greedy? Assets Under Management…

Data OverloadWhat’s Already in the Price?

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3) The Human Element in Investment Committees:

The Beauty Contest Following the CrowdAgent Risks & The Prudent Man RuleOver-confidence vs Random Events The Hot Hand The Search for Skill

a) The Beauty Contest

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Match client needs with agent skills

Agents acting wholly on behalf of

principals

Avoiding potential for divergent

motives

c) Agent Risks & The “Prudent Man Rule”

XYZ Company

Pension Fund

Investment Board

(Onlookers?)

Beneficiaries

c) Agent Risks

Evaluation versus Planning Horizons

Money Managers

Horizon = Forever

CFO

Pension Staff

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Horizon = 3-5 Years

Horizon = Forever

Horizon = 3-5 Years

Horizon = 30 Years

Consultants (Education…

Blame?)

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c) Agent Risks Myopic Loss Aversion:

Evaluation Horizon drives Asset Allocation…Not the Planning Horizon (Portfolio Life)Longer Evaluation Horizon… More Stocks More willingness to assume risk

Aspects of Investor Psychology Daniel Kahneman & Mark Riepe, Journal of Portfolio Management, Summer 1998

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c) Agent Risks & The “Prudent Man Rule”

Gain (loss)

Undisclosed Perceptions, Inc.Crispy Cream Diet CentersHarley Safety EquipmentBoston Red Sox B Shares New Orleans Health Foods

TOTAL

200,000200,000200,000200,000200,000

1,000,000

300,000310,000280,000120,000260,000

1,270,000

100,000110,000

80,000(80,000)

60,000

270,000

Cost Market

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4 in a row 50%

5 in a row 25%

6 in a row 20%

20 Coin FlipsHeads or Tails % Chance

d) Overconfidence vs Random Events

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d) Overconfidence vs Random Events

Prescription:

Result:

Compare to:

On Jan. 1, 1991 select last years top performing newsletter in Hulbert’s Digest. Invest $100,000. Follow advice for 1 year. Repeat process on each Jan. 1st investing assets at previous year’s end in hottest newsletter of previous year.

10 years ending December 31, 2000Your money = $70,752 (-3.4%/year)

S&P 500 = $497,371 (17.4%/year)

*Source: Mark Hulbert, New York Times, Sunday, Jan 21, 2001

d) Overconfidence vs Random Events

1

3

2

4

Where did first quartile managers come from?

QU

AR

TIL

EWhere did first quartile managers go?

8

8

11

14

41 8

16

11

6

41

1991-94 1995-98 1991-94 1995-98

Universe consisted of 162 institutional managers in Russell’s Growth, Market-Oriented,

and Value universes with 8 years of history ending 1998.

Example: Of the 41 managers in the top quartile for years 1991-1994,only 8 remained in the first quartile in years 1995-1998.

Source: Frank Russell Company

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100 Dart Throwers

100 Unskilled Managers

100 Skilled Managers

Statistically, how many managers will outperform the market?

(Assume skilled and skilled have mirror image +/- IRs)

50

46

54

50

43

57

50

41

59

1 year 5 years3 years

d) Overconfidence vs Random Events The Search for Skill

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d) Overconfidence vs Random Events Excess Returns are Variable (Alpha = 3%, Std Dev 6%, Info Ratio 0.50)

Continuous Underperformance for: 3 years: 20 times 4 years: 8 times 5 years: 3 times

Underwater vs Benchmark (DrawDown) for: 3 years: 66 times 10 years: 10 times 23 years: 1 time

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Conclusion

Human predispositions interfere with sound investment decision at all levels, including:

Individual decisions Institutional investment strategies Investment committee decisions

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Recommendations

Be aware of potential pitfalls and traps

Have a well thought out long-term investment plan

Although adjustments are recommended, stick to your plan

Make rational decisions, avoid emotional interference

Always make decisions on a portfolio context