Applications of behavioural finance

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Applications of behavioural finance

• Richard Chapman, Simon Pearse, Andrew Smith and
  Ian Sykes

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Key points

• Behavioural and neoclassical/standard finance are
  compatible
• Standard finance explains asset prices and
  allocations
• Behavioural finance explains institutions and
  products
• Understanding and controlling behavioural bias is
  vital as risk is transferred from institutions to
  individuals
• Actuaries advise institutions not individuals
  we have a major role in bias management

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This presentation

• Standard finance
• Behavioural finance
• Testing
• Combined approach
• Applications investment and pensions
• Our role

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Standard finance

• Assumptions
• Rational agents
• Good information
• Frictionless markets

• Predictions
• Efficient markets
• Diversified risky portfolios
• Irrelevance of institutional form

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Irrelevance results

• Coase Theorem
• Miller Modigliani Propositions
• Mutual Fund Separation Theorem
• Catch 22 of Option Pricing

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A robust model

• Conclusions may be true in aggregate even if
  false for individuals
• Individual irrationalities may cancel out
• Irrational individuals may be eliminated by
  rational arbitrageurs

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Behavioural finance

• Assumptions
• Systemic behavioural biases
• Limited arbitrage

• Predictions
• Inefficient markets
• Preferred institutional forms

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A bestiary of biases

• Loss aversion
• Confirmation bias
• Framing
• Anchoring

• Status Quo bias
• Home bias
• Representativeness
• Hindsight bias

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Testing rationality is hard

• Defining rationality
• Generalised utility functions
• Non-financial payoffs
• Hindsight
• Cost of being rational
• Aggregate behaviour

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Combined approach

• Standard finance explains asset prices and
  allocations
• Fit improves with technology
• Behavioural finance explains institutions and
  products

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The process

• Define the functions
• What does standard finance predict?
• Identify major frictions and failures
• Specify changes to structures

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Investment applications Intro

• Impact on capital markets
• Actions taken by investment managers
• Role of the investment consultant
• Impact of Myners review
• Behavioural Finance applies not only to capital
  markets but to all areas of finance.

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Capital Markets Background

• Natural place to examine theories of BF
• Considerable amount of research
• Managers vary in their belief of BF
• Three distinct areas addressed by Managers -
• Behaviour within companies they research
• Behaviour of other managers
• Behaviour within their own decision making

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Active management

• Optimism
• Overconfidence
• Confirmation Bias
• Over reaction / under reaction
• Triggers

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Role of Investment Consultant

• Translating impact of manager to Client
• Manager Bias
• Impact of BF on manager
• Use of BF by manager
• Client own Bias
• Consultant Bias

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Impact of manager to client

• Interpreting the information provided
• Researching the managers use of BF
• Investigating team dynamics
• Recognising key individuals

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Client Bias

• Replace manager sooner rather than later
  (Prospect theory)
• But what about the cost? (Myopic Loss Aversion)
  
• Keep things as they are (Status Quo Bias)
• Past Performance (Anchoring)
• Avoiding Overseas equities (Home Bias)
• Avoiding Derivatives (Hindsight Bias)

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Fitting it in with the Myners Review

• decisions should only be taken by persons or
  organisations with the skills, information and
  resources necessary to take them effectively.
• where Trustees elect to take investment
  decisions they must have sufficient expertise and
  appropriate training to evaluate critically any
  advice they take.
• Trustees to set up an Investment Sub Committee
• Explicit mandates and Transparency

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Investments - Conclusion

• Some but not all Managers already make allowance
  for BF in their decision making
• Consultants could make clients more aware of the
  impact of BF on managers and how some exploit it
• Consultants could also make clients more aware of
  the impact of their own behaviour on their
  decision making

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Pension applications

• Defined Contribution
• Savings decisions
• Asset mix decision
• Annuitisation decision

What is rational and what is irrational?
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Defined Contributions savings

• Framing Example
• Mr X can save between 0 and C
• Employer matches contributions up to C1
• Mr X pays C2
• How is Mr Xs choice influenced by C1?
• How would his decision change if there was no
  limit?

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Defined Contributions savings

• Anchoring Example
• Adviser A introduces a decision making tool
• Mr X follows advice given by tool and pays C3
• Would Mr Xs choice be different if he had made
  decision alone?
• Mr Xs choice may be anchored by the tool

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Defined Contributions asset mix

• Home Bias Example
• Is holding a significant holding in the stock of
  an individuals employer rational?
• What if the individual is compensated outside
  the DC arena for this high risk?

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Defined Contributions asset mix

• Framing Example
• Is choosing the default fund rational?
• Most members choose the default so perhaps it is.

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Defined Contributions asset mix

• Status Quo Example
• Once funds are chosen a member may stick with
  this decision.
• Members should be encouraged to review their
  funds and so should Trustees.
• Even when the funds are making a loss!

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Defined Contributions annuity decision

• Annuity Protection Fund Example
• A scheme offers an annuity protection fund
• Would a member be more likely to use it if his
  fund is more than he was expecting or less?
• Is he influenced by Prospect Theory?

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Defined Contributions annuity decision

• Drawdown Example
• A member can choose to defer drawing his pension
  or buy an annuity?
• Is his decision influenced by prospect theory,
  regret aversion or common sense?

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Defined Contributions annuity decision

• Choice of increases
• Member may choose no increase, increase at fixed
  rate, index linked or stock market linked?
• How does he choose?
• Is he influenced by Myopic loss aversion?

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Defined Contributions conclusion

• Behavioural Finance may be evident in DC decision
  making
• But it is difficult to tell
• Members may be making the wrong decisions based
  on their behaviour
• Trustees may want to educate members of the
  impact of their own behaviour

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The role of actuaries

• Actuaries advise institutions not individuals
• Institutions can exploit or manage behavioural
  bias
• Is there a conflict between client and public
  interest?

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Closing remarks

• Thanks to
• Co-authors Richard Chapman and Andrew Smith
• Other members of the working party
• Others who offered suggestions and guidance
• The usual disclaimers
• Comments/questions
• Suggestions for further research