An Introduction

I found a copy of item 3, of the to read list Irrational Exuberance - Shleifer (2000), so that is where I have started. The book was published just before the burst of the Internet bubble as Shleifer warned that the market was overpriced. The argument from academia was that the market was efficient so this shouldn't be the case. The market also stayed overpriced for so long that people who argued this were simply sidelined for not accepting the `new world'. It is a little strange reading this book after the burst, and subsequent inflation of a new bubble, and subsequent burst.

But this is case and point for the aim of this study. If an asset manager correctly assesses the market and makes the right decisions, aware that it is difficult/impossible to time the market... Can they keep their clients through that? If clients join just after significant outperformance, and leave just after the crash... the skill of the asset manager counts for nothing.

From behaviouralfinance.net , here is an introduction to the field of behavioural finance.

Wikipedia also provides a:

• History
• Methodology
• List of Topics
• ... Key Conclusions
• ... Key Figures and Scholars
• ... References 

Sewell's Behavioural Finance

Having discovered behaviouralfinance.net through the references to Mauboussin's `Decision Making for Investors', I realised the necessity for a fair amount of background reading into Behavioural Finance.

Martin Sewell, from University College London, gives a survey of all the major contributions since the field started in `An Introduction to Behavioural Finance.'

The bits that jumped out at me to look at further include a study by Thaler in 1980 where he identifies 5 problems that arise through biases in our decision making:

1. Underweighting of opportunity costs
2. Failure to ignore sunk costs
3. Search Behaviour
4. Choosing not to choose and regret
5. precommitment and self-control

The books I am probably going to try get ahold of and read (comments welcome of a better place to start) are, in likely order:

1. Inefficient Markets: An introduction to Behavioural Finance - Shleifer (2000)
2. Heurisitics and Biases: The Psychology of Intuitive Judgement - Khaneman et al. (2002)
3. Irrational Exuberance - Shleifer (2000)
4. The Psychology of Judgement and Decision Making - Plous (1993)
5. Beyond Greed and Fear - Shefrin (2000)
6. Simple Heuristics That Make Us Smart - Gigerenzer, Todd & the ABC Research Group (1999)

Clearly I can't buy every book that I would like to read, so I am going to have to ask people who may have books on a wish list if I can borrow them...

Decision Making for Investors

Michael.J.Mauboussin of Legg Mason provides some very useful insights and a whole lot of references to further read into in the paper, 'Decision Making for Investors'.

Unlike the believers in the efficient market hypothesis and advocates of index-linked investments, Mauboussin emphasises the need for a focus on process over short-term results in order to distinguish between luck and skill of investors.

He does believe that you can outperform arguing that 'super performers have more in common with one another that they do with the average participant in their own field.'

His paper approaches investor decision making from three angles:

1. Inputs from successful people in various domains.
2. Expected Value.
3. Heuristics and Biases and why we fail to calibrate probabilities and outcomes properly.

He highlights a further 3 strategies to avoid the problems:

1. Focus on process rather than the outcome.
2. A constant search for favourable odds.
3. An understanding of the role of time.

'Focus on establishing a superior process with the understanding that outcomes take care of themselves' - MJM

He quotes Robert Rubin:

Any individual decision can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because of the recognised possibility of failure in fact occurs. But over time, more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.

He quotes Nassim Taleb and discusses the asymmetric nature of stock market returns and the importance of fat tails. On the same subject he quotes Philip Anderson (Nobel Prize winning physicist):

Much of the real world is controlled as much by the "tails" of the distribution as by the averages: by the exceptional, not the mean; by the catastrophe, not the steady drip; by the very rich, not by the "middle class". We need to free ourselves from "average" thinking.

Finally he gives a number of challenges in order to overcome many of the problems he identified. These seem fairly generic and valuable not just in the sphere of making investment decisions. My challenge in the research I am doing will be to find tangible measures of how well we are doing at meeting these goals. Again, it seems though that these valid points all point to emotional intelligence, making a high quality decision and then the ability to 'just do nothing'. Here they are:

1. Try not to overestimate your abilities.
2. Actively challenge your own assumptions.
3. Ask disconfirming questions.
4. Realise that past events or prices are sign posts, not answers.
5. View decisions from various perspectives.
6. Seek information from a variety of sources.
7. Reframe questions.
8. Consider only future costs and benefits.

I would encourage the more eager readers to go to the original paper and then post any thoughts you might have on this paper in the comments section of this post.

Any other suggestions of other papers/books/articles to read would be appreciated.

Measures

I have yet to find Bogle's paper. One of the frustrations of doing a literature review is finding the literature to review! One article which I have found which take a different approach to Bogle is Davis Advisors.

They conclude with 7 pieces of advise:

• Avoid Self Destructive Investor Behaviour
• Understand That Crisises are Inevitable
• Don't Attempt to Time the Market
• Be Patient
• Don't Let Emotions Guide Your Investment Decisions
• Recognise That Short Term Performance Is Inevitable
• Disregard Short Term Forecasts and Predictions

Dalbar do an annual study called 'A Quantitative Analysis of Investor Behaviour' which at $750 is not something I can just download, but is referred to in the online Davis Article. The graph on page 2 illustrates the issue that is at the heart of why I am doing this research.

What I am also interested in doing is trying to find measures of how individual investment companies can implement to see how they are doing at helping their clients get the full performance of the fund.

Making the assumption that you have done your Due Dilligence on an investment company, understand and agree with their philosophy and have confidence in their process to achieve their goals... the obvious message from the articles, and even from Bogle (even though he rejects active management) is to do nothing.

There are likely two things that need to be measured:

1) Historical Gap between Fund and Clients Performance

2) Behaviour Measures that link to the suspected causes of value destruction. 

Are there quantitative measures for the 7 points mentioned by Davis?

Perhaps

1. Level of client activity measures like volatility of contributions. 
   
2. Measures of correlation between client activity and market volatility. If the market goes up, are there more subscriptions? If the market goes down, are there more redemptions?
   
3. Lapse Rates or measures of clients leaving.

Is it possible to get quantitative measures of client understanding and emotional capacity to handle the ups and downs? You certainly can't start doing tests for clients! It may require qualitative evaluation. But that obviously makes analysis harder.

Let me see if I can find some suggestion!

John Bogle

In my last post, I mentioned John Bogle's study. I have not yet read of much of his work. He does have a website, but what I am trying to find is the original study that he did comparing the Fund's Return to the average investor's return.

Most Fund's measure their historical performance since inception or over set periods (say 1, 3, 5 ,10 years). The measure used most often is the Time-Weighted Rate of Return (TWR) since this is not impacted by the cash flows into and out of the fund. It is a clean measure of what $1 invested in the fund would grow to over the period measure. The actual return (Internal Rate of Return  or IRR) is affected by cash flows. 

If you invest $1 and it grows to $5 in 6 months, so you get excited... who wouldn't be with 400% growth, and top your investment up to $100 ($95 more), then there is a 50% drop in the next 6 months.

Your Net Investment = $96

TWR = 150%

IRR = -72.6%

Clearly the fund manager has no control over when you choose to invest or disinvest. The problem comes in if you regularly choose to invest just after the fund has done really well and sell just after it has done badly.

So in this example, the TWR of 150% shows a very successful year for the fund, but the client has lost a lot.

This is a very short term and extreme example, but over time if the client is very active in entering and leaving the fund... there is no reason why their return should be the same as the funds.

Overview

Performance Alpha is not generated smoothly over time. There are inevitable periods of both extreme outperformance and underperformance. I do not believe it is possible to predict when these periods will be. The problem is that excluding the most significant periods of outperformance can dramatically affect a clients performance relative to the fund's performance. Anecdotally and from popular papers by John Boggle, for example, Clients have a habit of leaving after shorter periods of underperformance, and joining after periods of outperformance leading to clients within a fund underperforming the fund itself. I would like to do

• a literature review both of what research has been done on this subject.
  
• What measures of destructive client behaviour have been proposed
  
  • Pros and Cons of each measure
    
  • Examples
    
    • Behavioural Alpha
      
      • Fund Return over period vs. Clients IRR
        
      • Return if net contributions level over period vs. Clients IRR
        
    • Period Invested
      
    • Contribution Volatility Measure
      
• Whether there are additional measures that could be used
  
• What can be done to assist clients to protect any alpha creation
  
  • Have there been successful studies on how to do this?
    

Collaborative Research

I am starting this blog with the intention of doing a research paper and a presentation on the topic at the Convention of the Actuarial Society of South Africa in late 2009, and the International Convention in 2010.

The intention is two pronged.

Firstly, I am interested in the topic and think it is important that we find ways of measuring our effectiveness in meeting the needs of investors. This does not stop at creating out performance if that out performance can not be fed through to clients because of their decision making.

Secondly, I am interested in whether using new communication technology, we can increase the number of people willingly contributing to research.

I hope you will join me in seeing if it works?