Behavioural finance through the lifecycle...The task goal theory (Locke & Latham, 1990) postulates...

Behavioural finance through the lifecycle

Michael Drew, Director, Drew, Walk & Co

Agenda 1. Competition of ideas

2. Key themes

3. Lifecycle goals

4. Application: How we use behavioural finance to frame reward and risk

5. Concluding remarks

1. Competition of ideas

2015 SMSF Association National Conference www.smsfassociation.com

Competition of ideas (the theory room)…

Copyright © Nobel Media AB 2013 Photo: Niklas Elmehed http://www.nobelprize.org/nobel_prizes/economic- sciences/laureates/2013/fama-photo.html

Copyright © Nobel Media AB 2013 Photo: Alexander Mahmoud http://www.nobelprize.org/nobel_prizes/economic- sciences/laureates/2013/shiller-photo.html


Competition of ideas (the practice room) …

Rational agents (Homo economicus) • Rational • Self-seeking agents • Don't make systematic errors

Professor Eugene Fama (Chicago) • Efficient markets hypothesis Professor Milton Friedman (Chicago) • “If you put the federal government in charge of the Sahara Desert, in 5 years there’d be a shortage of sand.”

Behavioural finance • Less than rational (quasi-rational) • Psychological realism • Framing and heuristics

Professor Robert Shiller (Yale) • Irrational exuberance

Charles D. Ellis • “Las Vegas is busy every day, so we

know that not everyone is rational.”


Competition of ideas (the home room) …

• PhD (Economics), University of Queensland

• Q: How many economists does it take to change a lightbulb?

• A: None - If the light bulb needed changing the market would have already done it

• PhD (Org. Psychology), Griffith

University

• Q: How many psychologists does it take to change a lightbulb?

• A: None - The lightbulb has to really want to change

2. Key themes


What is behavioural finance?

“At the core of behavioral finance is the conviction that

increasing the realism of the psychological underpinnings of

economic analysis will improve economics on its own terms -

generating theoretical insights, making better predictions of

field phenomena, and suggesting better policy.”

Camerer and Loewenstein (2002) - http://www.hss.caltech.edu/~camerer/ribe239.pdf


Explosion of behavioural finance research …

http://www.google.com.au/imgres?imgurl=http://i.telegraph.co.uk/multimedia/archive/01382/thaler_1382581c.jpg&imgrefurl=http://www.telegraph.co.uk/news/uknews/law-and-order/8220014/Stop-buying-rounds-to-cut-binge-drinking-says-David-Cameron-adviser.html&h=287&w=460&tbnid=kmEc1ALoAraP6M:&zoom=1&docid=BfttYdcUOW6H4M&ei=C1_EVLSFFcK_mAWpxoGYBA&tbm=isch&ved=0CB4QMygDMAM http://www.google.com.au/imgres?imgurl=http://cdn.thedailybeast.com/content/dailybeast/articles/2013/04/26/daniel-kahneman-s-gripe-with-behavioral-economics/_jcr_content/body/inlineimage.img.503.jpg/1366943288198.cached.jpg&imgrefurl=http://bearmarketnews.blogspot.com/2013/11/daniel-kahnemans-gripe-with-behavioral.html&h=335&w=503&tbnid=2rivOEj1vk2COM:&zoom=1&docid=z0U1rJoYV642XM&ei=eF_EVLSSBaP3mQW0-ICIDg&tbm=isch&ved=0CCIQMygHMAc http://www.google.com.au/imgres?imgurl=http://img.tedcdn.com/r/images.ted.com/images/ted/da4cf2be5d40c0b74bdfd51882d6ba3c52571e22_800x600.jpg%253Fll%253D1%2526quality%253D89%2526w%253D800&imgrefurl=http://www.ted.com/talks/shlomo_benartzi_saving_more_tomorrow&h=600&w=800&tbnid=DnMIdWlqze6jgM:&zoom=1&docid=9nxAVa1CVOtOgM&ei=mF_EVO-zDOW6mQWZ24HYDg&tbm=isch&ved=0CB0QMygCMAI http://www.behavioralfinance.org/page-1741309


© Neil Bendle and Philip Chen 2013

Endowment effect

Sunk cost bias

Hyperbolic discounting

Reference dependence

Framing

Trust

Fairness

Loss aversion

Mental accounting

Dishonesty

Base rate neglect

Competitor orientation

Overweighting of small probabilities

Overconfidence

http://neilbendle.com/books/BehaviouralEconomicsForKidsWeb.pdf


The critical role of framing and heuristics …

Heuristic (Greek: “Εὑρίσκω”, “find” or “discover”) refers to experience - based techniques for problem solving, learning, and discovery Where an exhaustive search is impractical, heuristic methods are used to speed up the process of finding a satisfactory solution Examples of this method include using a rule of thumb, an educated guess, an intuitive judgment, or common sense

http://en.wikipedia.org/wiki/Heuristic


Some ‘young’ quasi-hyperbolic agents using insights from behavioural finance today…

With acknowledgement Prof. David Laibson for “quasi-hyperbolic agents” line. http://www.dailymail.co.uk/debate/article-1201536/Let-tell-secret-Bullingdon-posturing-David-Boris-Oxford-contemporary-looks-decadent-image.html http://2.bp.blogspot.com/_B9MT6pb5H-M/SW0TtHgCK6I/AAAAAAAAAnY/kE2afYPyu3A/s1600-h/ObamaColumbia2.jpg

3. Lifecycle goals


Lifecycle theory …

Source: Corrigan and Matterson (2009)


Clarity of goal is critical …

Researchers have found that goals play a critical role in people’s financial planning behaviours (Glass & Kilpatrick, 1998; Neukam & Hershey, 2003) According to researchers, goals affect individuals’ task performance through directing attention and action, mobilising efforts, increasing persistence (Locke, Shaw, Saari, & Latham, 1981) An important characteristic of goal settings, as indicated by Winnell (1987), is goal clarity since a clear goal may provide feedback on whether concrete objectives have been achieved

http://www.consumerinterests.org/assets/docs/CIA/CIA2012/2012-19%20financial%20goal%20clarity%20and%20risk%20tolerance%20-%20an%20experimental%20investigation.pdf


Task goal theory and clarity

The task goal theory (Locke & Latham, 1990) postulates that specific and difficult goals can lead to higher levels of performance relative to vague or easy goals From a social cognitive theory perspective, the power of goal setting derives from the influence of self-referent thinking processes (Cervone, Jiwani, & Wood, 1991) In other words, when trying to achieve a well defined goal, individuals will direct their attentions toward the relation between the benchmarks of the goal setting and their actual attainments



How do we typically frame the goal of retirement saving?

TIME-WEIGHTED FRAME OF SUCCESS

Pot of gold? Beating peers?

CPI + x% over rolling ten year periods? vs

WEALTH-WEIGHTED FRAME OF SUCCESS What’s the client’s objective?

What’s the liability? How much of my pre-retirement income can I replace in retirement?

How can we best DEFINE, FRAME, MEASURE, COMMUNICATE, EDUCATE and

REPORT success to our clients in these terms?



The theory room …

Drew and Walk (2014)


The practice room …


Framing meaningful goals through the life course …

Source: Gordon, G.M. (2001) University of Wyoming Cooperative Extension Service. Available from: http://eruralfamilies.uwagec.org/ERFLibrary/Readings/LifeCycleofFinancialPlanning.pdf


Optimal decision making is hard …

“What’s safe and what’s risky changes over the life course” Professor Michael Drew (Griffith)

• We are walking a constant tightrope of taking a prudent amount of investment risk at every stage of our lives

• Too little risk and we will fall short of the promise of endless summers; too much risk can deplete our super to the point we may never recover

• How then can we manage the risks that we face through our lives?

• What are the insights we can take from behavioural finance?


The portfolio size effect

It’s what you do when the largest amount of money is at risk that matters Due to this size effect, a client’s final investment outcomes become more sensitive to asset allocation in later years, relative to early years Therefore, the ordering, path-dependency or ‘sequencing’ of returns becomes the key driver of adequacy …

Basu, A. and Drew, M.E. (2009) Portfolio Size Effect in Retirement Accounts: What Does It Imply for Lifecycle Asset Allocation Funds, Journal of Portfolio Management, 35:3, 61-72.


Time-weighted returns are an input into wealth-denominated outcomes (goals-based investing)

Basu, A. and Drew, M.E. (2009) Portfolio Size Effect in Retirement Accounts: What Does It Imply for Lifecycle Asset Allocation Funds, Journal of Portfolio Management, 35:3, 61-72.


It’s all about goals (frames informed by life stage) …

The extraordinary events over the last decade (and their impact on retirement adequacy) have demonstrated there is an interplay between: • The amount of savings at risk (‘the portfolio size effect’); and

• The realised ordering or sequence of returns (‘sequencing risk’)

experienced by clients Risk is more complex than simply deviations from what is expected … it is the wealth-weighted impact of adverse events on client goals

4. Application: How we use behavioural finance to frame reward

and risk*

*Bianchi, R, Drew, M, Evans, M and Walk, A 2014, 'The two faces of investment performance and risk', JASSA: The Finsia Journal of Applied Finance, no. 1, pp. 6-12.


Competing frames of reward and risk …

Bianchi, R, Drew, M, Evans, M and Walk, A 2014, 'The two faces of investment performance and risk', JASSA: The Finsia Journal of Applied Finance, no. 1, pp. 6-12.


Data Two assets – Stocks and cash Data • US stock market (Rm) and 1-month US government Treasury bills (Rf) for the period

July 1926 to December 2011 (n = 1,026) (French, 2012) • Nominal returns

Investment horizons – 1, 5, 10, 15, 20, 25, 30, 35, 40 years Simulation – 10,000 trials per horizon using stationary bootstrap technique (Politis and Romano, 1994) Five strategies: 100% stocks, 100% cash, Balanced (60%/40%), TDF (linear decline from 80% to 56% stocks over last 20yrs), Dynamic strategy Target RWR of 9.9x for 40 year horizon (Desired target return = nominal 7% p.a.)

Bianchi, Drew, Evans, and Walk (2014)


TWR (1)

Results: • Fit expectations • Return/ risk trade-off

similar in each case • Dynamic, stocks look very

similar • Downside risk similar Weaknesses: • Ignores factors other than

returns (wealth)

Strategy Mean St.Dev. Sharpe Negative return

Stocks 10.93% 18.51% 0.4009 1 in 3.6yrsBalanced 7.96% 11.10% 0.4009 1 in 4.2yrs

TDF 9.00% 13.77% 0.3987 1 in 3.8yrsDynamic 10.50% 17.59% 0.3974 1 in 3.6yrs

Cash 3.51% 0.81% 0 Never

Time-weighted performance and risk measures (five strategies; 40 year horizon)



TWR (2) Consistent with finance theory:

• Combination of two assets • Classical CML • Differentiate based on risk

tolerance only

Open questions:

• Is this the whole story? • Are dynamic, stocks so

similar? • What do we get in

retirement? • What if the frame

changes?

Cash

BalancedTDF

Dynamic Stocks

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

0.00% 5.00% 10.00% 15.00% 20.00%

Mea

n

Standard deviation

Return-risk trade-off (five strategies; 40 year horizon)



WDP (1)

A new frame:

• Performance isn’t as close as it looks in TWR terms

• Picture is richer than the TWR measures suggest

• Return/ risk trade-off differs widely

• Targets matter

Strategy Median RWR

P(Shortfall) E(Shortfall) Sortino

Stocks 20.41 20% 0.67 9.97Balanced 11.35 39% 1.06 1.35

TDF 13.73 30% 0.82 3.35Dynamic 17.94 16% 0.56 7.95

Cash 4.21 100% 5.48 -0.98

Wealth-denominated performance and risk measures (five strategies; 40 year horizon)



WDP (2)

Through a wealth-denominated lens interesting findings emerge … Dynamic strategy has:

• Lowest probability of shortfall

• Lowest expected shortfall • Second best Sortino ratio

Probability of shortfall (four strategies; all horizons)



WDP (3)

Sortino ratio (four strategies; all horizons)

0123456789

10

1 5 10 15 20 25 30 35 40Investment horizon (years)

Dynamic TDF Balanced Stocks

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1 5 10 15 20 25 30 35 40

Shor

tfal

l (R

WR

uni

ts)

Investment horizon (years)

Dynamic TDF Balanced Stocks

Expected shortfall (four strategies; all horizons)



Insights from behavioural finance …

Time-weighted measures: • One dimensional, in abstract terms

• Because risk-adjusted performance is virtually identical for each strategy, we can only

differentiate between strategies based on risk tolerance

• Using these measures, we have little idea about what I might be able to expect in retirement



Richer insights? We would argue greater goal clarity...

Wealth-denominated measures:

• Richer picture, in intuitive terms

• Improves evaluation of retirement portfolios (compared to TW measures)

• Target-relative performance and risk measures useful in focusing attention on the purpose (the goal) of retirement savings: funding retirement

• Target-aware investment strategies may increase the probability of achieving the retirement objective (without giving up much in terms of time-weighted performance)


5. Concluding remarks


Rubber on the road …

A terrific quote by Warren Cormier (2014), co-founder of the ‘Behavioural Finance Forum’ (now owned by RAND Corporation) …

“After attending a behavioural finance event, a common

observation from audience members is: That was fascinating, but what do I do now?”

We will go for three takeaways …


1. Framing really, really matters …

People respond differently to questions depending how the questions are asked Your choice of communication strategy matters to the decision that will be made (Madrian and Shea, 2001 and Bendle and Philip Chen 2013) …


“I prefer mummy sharing the bad news about bedtime strategically.”

© Neil Bendle and Philip Chen 2013 http://neilbendle.com/books/BehaviouralEconomicsForKidsWeb.pdf


2. Heuristics (mental short cuts) are ‘hard-wired’

Reflect on how many (and frequently) you and your clients use these rules in the face of complexity (this is a good news/bad news story) … • Pareto’s principle - the 80/20 rule (Pareto created a mathematical formula to describe

the unequal distribution of wealth in Italy, observing that twenty percent of the people owned eighty percent of the wealth)

• Rule of 72 - if you invest your money at a certain rate of return, you can figure how many years it will take for your money to double by dividing 72 by the rate

• The Golden or 4% Rule - Bengen (1994) “… assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 per cent, followed by inflation-adjusted withdrawals in subsequent years, should be safe (p.172).”


Using behavioural finance in client presentations …

Payout 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

10yrs 100% 100% 100% 100% 100% 100% 98% 93% 86% 82%

20yrs 100% 100% 100% 98% 88% 67% 53% 40% 29% 21%

30yrs 100% 100% 99% 82% 60% 37% 27% 17% 7% 5%

40yrs 100% 100% 93% 58% 40% 28% 17% 7% 4% 1%

Payout 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

10yrs 100% 100% 100% 100% 100% 100% 100% 96% 94% 84%

20yrs 100% 100% 100% 100% 92% 71% 46% 32% 26% 11%

30yrs 100% 100% 100% 88% 52% 29% 16% 10% 6% 1%

40yrs 100% 100% 100% 58% 32% 10% 3% 3% 0% 0%

New Zealand

Australia

Payout 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

10yrs 100% 100% 100% 100% 100% 100% 100% 99% 85% 70%

20yrs 100% 100% 100% 100% 82% 55% 42% 33% 20% 12%

30yrs 100% 100% 100% 70% 43% 22% 13% 9% 6% 4%

40yrs 100% 100% 96% 42% 17% 3% 0% 0% 0% 0%

Netherlands

Payout 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

10yrs 94% 92% 92% 91% 91% 91% 89% 85% 84% 78%

20yrs 84% 82% 80% 80% 75% 68% 55% 43% 28% 18%

30yrs 76% 71% 68% 62% 57% 44% 26% 11% 10% 7%

40yrs 67% 50% 49% 47% 42% 28% 14% 11% 8% 6%

Japan

Payout 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

10yrs 100% 99% 95% 95% 93% 86% 80% 76% 67% 64%

20yrs 100% 89% 82% 53% 49% 41% 36% 27% 15% 5%

30yrs 95% 85% 43% 24% 18% 12% 7% 4% 1% 1%

40yrs 86% 49% 18% 10% 1% 0% 0% 0% 0% 0%

Italy Drew and Walk (2014)


3. How is your choice architecture presented?

“Choice architecture refers to the fact that every aspect of the choice environment affects the choice we make …” “EVERYTHING we say or do affects people decisions” (Cormier, 2014)

Pots of gold (what’s your number?) vs

Sustainability of retirement income (what’s your liability?)


The last word …

“People in standard finance are rational. They are not confused by frames, they are not affected by cognitive errors, they do not know the pain of regret, and they have no lapses of self control. People in behavioural finance may not always be rational, but they are

always normal. Normal people are often confused by frames, affected by cognitive errors and know the pain of regret, and the difficult of self control.”

Professor Meir Statman (Santa Clara)

[NO PSYCHOLOGISTS WERE HARMED DURING THE MAKING OF THIS PRESENTATION]


Disclaimer

© Drew, Walk & Co. 2014

This presentation is for general information only. Every effort has been made to ensure that it is accurate, however it is not intended to be a complete description of the matters described. The presentation has been prepared without taking into account any personal objectives, financial situation or needs. It does not contain and is not to be taken as containing any securities advice or securities recommendation.

Furthermore, it is not intended that it be relied on by recipients for the purpose of making investment decisions and is not a replacement of the requirement for individual research or professional tax advice. This presentation was accompanied by an oral presentation, and is not a complete record of the discussion held. No part of this presentation should be used elsewhere without prior consent from the author.

Behavioural finance through the lifecycle...The task goal theory (Locke & Latham, 1990) postulates...

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