Risk Management Ebook


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Risk Management Ebook

  1. 1. The Bullish BrainRisk Management(And Why You Stink At It)The Risk Management (and Why You Stink at it) series is brought to us byDr. Daniel Crosby. Dr. Crosby is an organizational psychologist whoseclients include Morgan Stanley/Smith Barney, RS Funds, Grant Thorntonand Appleton Learning. You can reach Dr. Crosby atDaniel@bullishbrain.com , read his blog at www.bullishbrain.com or followhim on Twitter @bullishbrain.1 2 3 4 M a i n S t r e e t , A n y t o w n , S t a t e 5 4 3 2 1 • t e l e p h o n e : 1 2 3 . 4 5 6 . 7 8 9 0 • f a x : 1 2 3 . 4 5 6 . 7 8 9 1 • w w w. a p p l e . c o m / iwork
  2. 2. Part 1:The Availability HeuristicYou stink at assessing risk. There, I said it! The thing is, I stink at assessing risk too. People ingeneral are prone to a number of errors in judgment when appraising risk, and while being awareof them is no sure fix against investing poorly, it’s at least a start. This will be Part One of a sixpart series on errors in risk assessment; I hope our coverage of this topic gives you some toolswith which to adjust your thought process the next time you are attempting to evaluate theriskiness of a given investment.ALPHABET SOUPLet’s begin by having you name all the words you can that begin with the letter “K.” Go on, I’mnot listening. How many were you able to come up with? Now, let’s have you name all of thewords in which K is the third letter. How many could you name? If you are like most people, youfound it easier to generate a list of words that begin with K – the words probably came to youmore quickly and were more plentiful in number. But, did you know that there are three times asmany words in which K is the third letter? If that’s the case, why is it so much easier to create alist of words that start with K?It turns out that our mind’s retrieval process is far from perfect, and that a number of biases playinto our ability to recall information (and thus, use that information to assess risk). Our memoryis better for things at the beginning and the end of a list (like the letter K), things that are scary,and things that are incomplete. If asked to assess the prevalence of Words Beginning With K vs.Words With K As The Third Letter, you likely would have picked the former because of thisfallibility in your memory retrieval mechanism. Psychologists call this the “availability heuristic”,which simply means that we predict the likelihood of an event based on things we can easily callto mind. Unfortunately for us, the imperfections of the availability heuristic are hard at work aswe go about our financial lives and attempt to make good investment choices. 2
  3. 3. DUH NUH DUH NUH DUH NUH DUH NUH DUH NUHRoughly five years ago, I had just recently married my wife and we had moved to the North Shoreof Hawaii for a six month internship. Although our lodging was humble, we were thrilled to betogether in Paradise and were eager to immerse ourselves in all the local culture and naturalbeauty had to offer. That is, until I turned on Shark Week. For the uninitiated, Shark Week is theDiscovery Channel’s seven day binge of all things finned and scary. A typical program begins bydetailing sharks’ predatory powers, refined over aeons of evolution, as they are brought to bearon the lives of some unlucky surfers (FYI – surfers look like seals from below). As the show nearsit’s end, the narrator typically makes the requisite plea for appreciating these noble beasts, amessage that has inevitably been overridden by the previous 58 minutes of fear-mongering.For one week straight, I sat transfixed by the accounts of one-legged surfers undeterred by theirill fortune and waders who had narrowly escaped with their lives. Heretofore an excellentswimmer and ocean lover, I resolved at the end of that week that I would not set foot in Hawaiianwaters, and indeed I did not. So traumatized was I by the availability of bad news, that I foundmyself unable to muster the courage to snorkel, dive, or do any of the other activities I’d solooked forward to just a week ago. 3
  4. 4. JUST THE FACTS MA’AMThe parallels between a tourist surrounded by water watching Shark Week, and an investor gluedto the latest Doomsday Prophet on cable news are almost too obvious to mention. Just as SharkWeek is Discovery’s Sweeps Week darling, the dour and naysaying have become the bread andbutter of the 24 hour cable news cycle. But whether your favorite talking head is bullish orbearish, the fact is that their opinion looms larger in your mind than it ought to. To return brieflyto my cowardice, consider the facts about the likelihood of a shark attack – the odds of me gettingaway with murder (1 in 2), being made a Saint (1 in 20 million), and having my pajamas catch onfire (1 in 30 million), were all exponentially greater than me being bitten by a shark (1 in 300million). My perception of risk was warped wildly by my choice to watch a program that played onhuman fear for ratings and my actions played out accordingly.LIVED LEARNINGObviously, learning about the availability heuristic and its contorting effect on risk perception isonly worthwhile if we apply it in our lives as investors. I suggest the following as a jumping offpoint:Be an informed viewer – When you do choose to watch TV, grab a paper and pencil and make anote of every time fear-based, sensational, or cliffhanger (e.g., “Could your dinner kill you? Findout at 10!”) techniques are used to drive ratings and grab your attention. Television can be avaluable source of information, but should be watched with a critical eye.Become a student – Do not rely solely on your preferred talking head or pet network to provide100% of your decision-making data. Consult people of various dispositions, political leanings,and views on the market. Seek out a diversity of opinions and media and examine theassumptions underlying the various prognostications. 4
  5. 5. Part 2:The Affect HeuristicNotwithstanding the fact that you’re grandma thinks that you are such a nice boy and that yourMom thinks you are handsome – we have already established that you stink at assessing risk. Inmy last post, we discussed the availability heuristic as it impacts your ability to assess risk.Today, I’d like to touch on the affect heuristic.DEBBIE DOWNERWhen giving a seminar on risk assessment as it relates to investing, I often ask participants towrite down the word, that if it were spelled phonetically, would be “dahy”. Go on, write it downand don’t overthink it. It turns out the way you spelled the word has a lot to do with the kind ofday you are having. Those that spelled the word as “die” may need a hug, while those thatspelled the word “dye” are probably doing alright. The reason this is the case is that our moodhas a great deal to do with how we retrieve memories and consequently, how we assess risk.ROSE COLORED GLASSES OR “I WEAR MY SUNGLASSES AT NIGHT?”One of the reasons psychologists can charge $200/hr to ask, “How does that make you feel?”is that we have gotten great at putting fancypants labels on things that would otherwise be veryintuitive. Take for instance the tongue-twisting affect heuristic, which is simply a reference toour tendency to perceive the world through the lens of whatever mood we are in. 5
  6. 6. Ask someone having a bad day (those that wrote “die”, I’m looking at you) about their childhoodand they are likely to tell you how they were chubby, had pimples, and never got picked first atkickball. Conversely, ask someone having a good day about their childhood and they are likely torecall summers in Nantucket and triple dips from the Tastee Freeze. Memory and perception aremoving targets colored by our mood, NOT infallible retrieval and evaluation machines throughwhich you make unbiased decisions.WHO CARES?So what is the moral of all of this psychobabble for the average investor? Think back on the lasttime that you went shopping when you were hungry. Once you’ve brought that to mind, thinkback on the contents of your shopping cart. If you’re like me, you probably had a whole mess ofHoHos, Ding Dongs, Nutty Buddies, and Diet Coke (you don’t wanna get fat, after all), butnothing very healthy or substantive.The same rules apply to investing and trading; if you try to make decisions about the riskiness orviability of a given investment product when you are happy/sad/angry/in love/anxious/worried/euphoric, you are likely to end up with a portfolio full of junk food. So, the next timeyou are about to call your broker in a fit of rage (or right after getting engaged), take a step back,breath deeply, and let time bring you back down to Earth. After all, shopping while you’re hungrycan make you sick. 6
  7. 7. Part 3:The Illusion of ControlYOU GOTTA KNOW WHEN TO FOLD ‘EMPerhaps nowhere is human fallibility more prominently displayed than in Vegas. Noveltyalcoholic beverages, garish lights, and smoke-filled labyrinths aren’t just a good time, they alsoteach a lot about how we make decisions. So what can the City of Sin teach us about yourtendency to want control?Obviously, people have a vested interest in feeling competent and in control. In fact, thedefinition of stress that I find most useful is “the loss of perceived control over an event.” Sowhile the obvious upside of this tendency to feel in control is a perception of personalcompetence, the downside is that we tend to think we can control random events as well.Let’s say I offered to sell you a lotto ticket that provided you a 1 in 50 chance of winning aprize. How much would you pay if I told you that I’d take your money, select a ticket randomly,and that would be your number? Now how much would you pay if I offered to let you choose your 7
  8. 8. ticket from among the 50 available, allowing you to pick your daughter’s birthday or the numberof Twinkies you ate to win that contest (ah, glory days).When psychologists run this experiment, people pay $1.96 on average for the tickets thatare given to them and $8.67 on average for the tickets where they are allowed to choose thenumber! Obviously, the odds are the same in both conditions, 1 in 50, but our confidencethat we control the universe is such that we are willing to pay 4.5 times more to be in charge.WHO’S THE BOSS?Another example of our propensity to overvalue our own influence is the tendency of people tooverinvest in their own organization’s stock for the stated reason that they can directly impact thestock price. So, Suzie from accounting is going to invest in Coca-Cola because she feels thevaluation of the world’s greatest brand lives and dies on the skill of her beancounting.HINT: If you, in isolation, can directly impact the rise and fall of your stock, and make personalinvestment decisions accordingly – you might be going to jail soon. For the rest of us peons, ourdaily travails don’t matter much one way or the other in the ultimate success or failure of apublicly traded company and it’s best not to invest as though they do.WHAT NOW?But Dr. Crosby, now that I know that I don’t control the universe, what do I do now? First off,you can stop blaming yourself for not seeing the downturn coming, because you didn’t controlthat either. Second, you can embrace the uncertainty of the markets. The volatility of investing iswhat provides significant upside risk. The reason the market has averaged 9% percent yearlyyields over the last hundred plus years is because it’s risky. You take a chance and are rewardedaccordingly – if everyone were truly in control it would be no different (and no more lucrative)than putting your nickels in a Mason jar. Finally, exert your energy in areas that matter – studyeconomic cycles, study consumer behavior, learn about historical market trends. The bad newsis, your presence alone isn’t going to drive up a stock, but that doesn’t mean you aren’tpowerful in other ways. 8
  9. 9. Part 4:The Illusion of UniquenessIs  your  spouse  out  of  the  room?  Good.  Let  your  mind  wander  for  a  second  back  to  your  4irst  high  school  love.  Do  you  remember  how  intense  your  feelings  for  them  were?  Do  you  recall  that  sick  feeling  in  your  gut  when  you  were  apart  from  them?  The  profound,  undeniable  sense  you  had  that  no  one  had  ever  experienced  a  love  as  deep  or  as  pure  as  what  you  were  now  feeling  for  John  Q.  Quarterback/Suzie  Q.  Cheerleader?But along the way, something happened and your love went unrequited. You searched for solacefrom friends, siblings, parents, perhaps even a shrink, all to no avail. Because no matter howmany trees you killed in Kleenex form and no matter how many times you told the story ofyour heartbreak, NO ONE EVER GOT IT. How could they after all? Mere mortals could neverunderstand the unique splendor of what you had experienced with your Schnookums!   9
  10. 10. Psychologists call this illusion of uniqueness personal fable, and it hurts investors at least asmuch as twitterpated adolescents.SURE THAT COULD HAPPEN – TO THEM!Cook College performed a study in which people were asked to rate the likelihood that a numberof positive (e.g., win the lottery, marry for life, etc…) and negative (e.g., die of cancer, getdivorced) events would impact their lives. What they found was hardly surprising – participantsoverguessed the likelihood of positive events by 15% and underguessed the probability ofnegative events by 20%. What this tells us is that we tend to personalize the positive anddelegate the dangerous. I might win the lottery, she might die of cancer. We might livehappily ever after, they might get divorced. We understand that bad things happen, but inservice of living a happy life, we tend to think about those things in the abstract.The risk management implications of perceived uniqueness are obvious – if we make decisionswith the mindset that we are a unique snowflake, we are likely to ignore potential risks. If ourinvestment lives are uniquely ours, we inevitably ignore lessons from history and from watchingothers. Worse still, if we perceive upside potential to be “all us” and losing to be the birthright ofthose other schmucks, we’re bound to do stupid things.GOOD AND BAD NEWSSo, if you missed the sarcasm dripping from the top of the page, let me point out to you that yourrelationship with Mr. Hunkyface was probably not as unique as you imagined it to be at the time.What’s more, your a lot less likely to hit the jackpot than you might expect. But here’s the trick,by understanding that you’re not all that special, you put yourself in a position to makeexcellent decisions that might just make your life, well, special. 10
  11. 11. Part 5:GroupthinkALL I REALLY NEED TO KNOW I LEARNED AT A GAUDY HOLE IN THE WALLI am privileged to be a part of the Speaker’s Bureau for Guardian/RS Funds and recently foundmyself with members of the RS team in San Antonio, TX for the Advisor Group Women’sConference. Before my presentation on The Art and Science of Persuasion the next day, a few ofus decided to grab dinner along San Antonio’s historic Riverwalk. The Riverwalk is beautiful;tucked one level below the automobile street and lined with restaurants, shops, and hotels, itoffers no shortage of options for the hungry traveler in search of some good TexMex cuisine.After meeting my colleagues at a nearby hotel, we began to wander the labyrinthine streets ofPaseo del Rio, passing a number of excellent restaurants but never stopping. 11
  12. 12. Having not determined any clear criteria for selecting a dinner spot, we continued to wanderuntil we were accosted by an enthusiastic host at a garish Mexican restaurant. After rattling off alist of run-of-the-mill TexMex offerings, he moved on to describing the house drink specials,which sounded similarly unspectacular. So how was it, that just moments later, our five-personparty of foodies was seated at a sticky table at this culinary also-ran? The answer lies in ourpropensity to try and read others’ minds and act in ways that are consistent with their desires –somehow, someway, everyone in our party got the idea that everyone else in the party wanted toeat at this tacky dive, and dared not speak up lest they offend the others. The result is is whatsocial scientists call “mismanaged agreement”, as illustrated by The Abilene Paradox (what’sup with Texas and poor decisions anyway?). Our tendency to want to read minds and our inabilityto do so, can result in something much more dire than a stomach full of stale chips – thispropensity to engage in groupthink is the sort of behavior that creates and eventually burstsfinancial bubbles.YOU ARE LAZYOk, maybe not you, but your brain is definitely lazy. As a student of human behavior, there areprecious few things that I would state as approximating a law. One of the few ideas that comeclose for me is that people are cognitively lazy and will consistently use decision-makingrules of thumb rather than reinvent the decisional wheel each time. After all, every day ofyour life is filled with decisions to be made – Diet Coke or Diet Pepsi (Answer: Coke)? Should Irun or stay in bed? Do I wear the black or the grey suit? Without heuristics, or experientiallybased rules of thumb for making decisions, life would become paralyzing and we would get verylittle done. Although there is considerable upside to decision-making heuristics, one of our mostcommon fallbacks is to rely on the decisions of others, a trend that can lead us to make poorinvestment decisions.A LESSON FROM THE STREET (NO, NOT WALL STREET)Consider the last time you were asked for money by a person on the street. Perhaps thisindividual approached you with a cup or a tin, which may or may not have had any money in it 12
  13. 13. already. Stop for a moment and consider with me who you would more likely donate moneyto – a person whose cup was empty or someone whose cup showed evidence of the generosityof previous passersby? It seems intuitive, that all other things being equal, the person with theleast money in their cup is the one more deserving of your largesse. After all, if they are begging,they may not have adequate financial means to meet their basic human needs. The less moneythey have, the more they could benefit from your donation, right?This being the case, why is it that researchers consistently find that passersby give more money tothose whose cups already have money? The answer is simple – an empty cup is seen as ajudgment of unworthiness by previous onlookers. Although we may not fully comprehend all ofthe reasons they are unworthy of our donation, we are likely to follow the lead of those who havegone before and withhold our offering. Switch gears here with me – by basing our decision onthe decisions of others, we have overlooked a logical component of decision-making (in this case,need) and relied instead on a choice strategy that may have little to do with what ought to be ourprimary concern.RISKY BUSINESSWe have discussed the ways in which groupthink can lead us to make unsatisfying decisions (likenasty salsa) and illogical decisions (like helping the wrong person asking for money), but can italso lead us to make risky decisions? Prior to the 1980ʹ′s, the conventional logic said that whengroups of people got together, the decisions they made would look something like the average ofthe risk tolerance of the group as a whole. However, what research has borne out time and againis that groups tend to make decisions that are far riskier than the decisions that would be made bythe individuals themselves (ever heard of a soccer hooligan?). It turns out that as group sizeincreases, the perceived responsibility for outcomes lessens. With this lessened degree of feltresponsibility, it becomes easier to make decisions that may risk personal or financial wellbeing,since after all, it wasn’t just MY decision.Pause for a moment and think about your friend who just “gets investing.”  You know, the friendwho always “sees it coming” and is quick with a great stock tip? Consider this – although your 13
  14. 14. friend may mean well, what he is effectively doing is recruiting you to engage in groupthink. If heis successful in doing so, he can pat himself on the back for making a decision that now enjoyssocial proof, while simultaneously reducing his psychological vulnerability to risk. After all, ifthings fall apart, he’s not the only dummy who picked that stock. But caveat emptor dear reader,because while groupthink may offer a soft landing for your ego, I promise that it hasprecious little solace to offer your wallet. 14
  15. 15. Part 6:Loss AversionZOMBIES!!!The year is 2012. All of those Mayan calendar people you thought were wackos turned out to beright, and the world as we know it is falling apart. Zombies roam the countryside, infectingpeople with a heretofore unknown disease. As the President of Yourfirstnamehere-istan, youhave been approached with two plans and must make a choice that will have far-reachingimplications for the 600 citizens of your once-fair land. The two plans presented to you are asfollows:   Plan A – If adopted, 200 people will be saved. Plan B – If adopted, there is a 1/3 chance that all 600 citizens will be saved and a 2/3 chance that none will be saved. 15
  16. 16. Have you made your decision El Presidente? When you have, stand at your desk, pound yourfists on the table and shout, “As the most high sovereign ruler of Yourfirstnamehere-istan, Ideclare that it shall be Plan ____!” But wait, a messenger has arrived with a second set ofoptions, they are: Plan C – If adopted, 400 people will die. Plan D – If adopted, there is a 1/3 chance that no people will die and a 2/3 chance that 600 people will die.So, which plan did you initially choose – A or B? What about from the second set of alternatives –C or D? If you are like most people the decisions you made have a great deal to do with your ofloss.AFRAID TO FAILIf you take a minute to consider the options put before you above, you’ll notice that options Aand C are identical probabilities, as are B and D. That being the case, why is it that people chooseA over B at a 3 to 1 ratio, and D over C at a 4 to 1 ratio? Doesn’t make sense does it? Until youconsider the framing of the questions – questions framed as a loss are avoided in both cases.Social psychologists who study loss aversion find that people are typically twice as upsetabout a loss as they are pleased about a gain. I’m sure it took a decade and millions of dollars totell you what my Dad, a financial advisor with Morgan Stanley/Smith Barney could have told you.His phone doesn’t ring much when he is making people money, but he got a lot of calls in 2008and 2009.LIFE AND LOSSIt goes without saying that no one likes to lose money; in this sense our fear of loss is natural andcan be protective at times. However, it can also be damaging at times when it distorts our view of 16
  17. 17. the world or leads us to not even play the game. I’d like for you to consider the most meaningfulthing you have ever done. I’m not sure what it is, probably couldn’t even get in the ballpark.What I would wager however, is that it took a measure of risk, uncertainty, and hard work toachieve. To strive for certainty is to doom oneself to mediocrity. The irony of obsessive lossaversion is that our worst fears become realized in our attempts to manage them. The onlyway to never risk heartbreak is to never love, but what could be more heartbreaking thanthat? The only way to never risk failing is to never try, but not trying is the greatest failure ofall. 17