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Best Practices in Applied Behavioral Finance
- 1. Best Practices in Applied Behavioral Finance The Georgia Society of CPAs April 20, 2012 Presented by: Tyler D. Nunnally Founder & CEO Upside RISK
- 2. Presentation Overview Part I: Introduction Part II: Behavioral Finance 101 Part III: Risk Tolerance Part IV: Best Practices © 2012 Upside Risk Corporation. All rights reserved.
- 3. “Risk management is a form of engineering: it uses science, but ultimately depends on judgement… The ultimate protection against risk is good judgement and alertness: your own and that of your colleagues”. Source: Risk Management, November 2005
- 4. “Mind the Gap” in ERM Financial Crisis Inquiry Commission “We conclude this financial crisis was avoidable. The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire… To paraphrase Shakespeare, the fault lies not in the stars, but in us”. Source: http://www.fcic.gov/ © 2012 Upside Risk Corporation. All rights reserved.
- 5. Presenter Background ‘92 Summer Olympic Games (Barcelona, Spain) ‘93 Nunnally International Trade, Inc. (Prague, Czech Republic) ‘03 University of St Andrews (St Andrews, Scotland) ‘04 Global Business Consulting (Barcelona, Spain) ‘06 Oxford Risk Research & Analysis Ltd (Oxford, England) ’09 Upside RISK (Atlanta, Georgia, USA) © 2012 Upside Risk Corporation. All rights reserved.
- 6. PART II: Behavioral Finance 101 © 2010 Upside Risk Corporation. All rights reserved.
- 7. What is Judgment Risk? Probability Magnitude of Occurrence Risk of Likely Impact Behavioral Biases X Risk Tolerance “JUDGMENT RISK” © 2012 Upside Risk Corporation. All rights reserved.
- 8. The Way People Make Decisions SYSTEM 1 SYSTEM 2 (Intuitive) (Reason) Automatic Thoughtful Spontaneous Controlled Unconscious Informed Instinctive Deductive “Gut feel” Analytical © 2012 Upside Risk Corporation. All rights reserved.
- 9. Sample Size Bias There are 2 banks that serve Chester County. On average, the larger bank records $45 million deposits per day and the smaller bank records about $15 million deposits per day. The exact percentage varies from day to day. For a period 1 year, each bank recorded the days on which more than 60% of deposits fell above or below their daily averages. Which bank do you think recorded more such days? A. Large bank B. Small bank C. Same for both banks D. Neither bank recorded such day © 2012 Upside Risk Corporation. All rights reserved.
- 10. Behavioral Biases Booms and Busts: Housing market and subprime loans Behavioral Biases: - Time Discounting - Confirmation Bias - Loss Aversion - Herding - Overconfidence © 2012 Upside Risk Corporation. All rights reserved.
- 11. Overconfidence “I Guarantee It” • 90% drivers say they are “above average” • 94% professors think they are “better than average” • Majority of MBA believe they will fair better than classmates Interventions: • Think it through • Do not act purely on intuition • Ask for second opinion but avoid “yes men” © 2012 Upside Risk Corporation. All rights reserved.
- 12. Time Discounting “Buy Now – Pay Later” • Explosive growth of credit card industry • Short-term strategies (analysts expectations) • Long-term consequences (systemic risk) Interventions: • Think ahead • Impact of decision in 5 years time – longer when stakes are high • Imagine yourself and family in 5, 10 – 20 years © 2012 Upside Risk Corporation. All rights reserved.
- 13. Confirmation Bias “Don’t Rock the Boat” • Group Think • Risky Shift • Dangerous Risk Culture Interventions: • Devil’s advocate • Avoid “yes men” • Triangulate data © 2012 Upside Risk Corporation. All rights reserved.
- 14. Status Quo Bias “Risk Avoidance is our Strategy” • Loss aversion • Failure to adapt… left behind • Missed opportunities Interventions: • Atari, Xerox, Woolworths, Gateway, Kodak, RIM… • Recruit some risk-takers and DEVELOP them © 2012 Upside Risk Corporation. All rights reserved.
- 15. PART III: Risk Tolerance © 2010 Upside Risk Corporation. All rights reserved.
- 16. Risk Domains Risk Propensities Compartmentalized into Separate Domains RISK DOMAINS Health/ Financial Recreation Ethical Social Safety For instance, a heavy drinker and smoker may take health risks, but he is not necessarily the same guy who makes high risk investments with his 401(k). © 2012 Upside Risk Corporation. All rights reserved.
- 17. Risk Profiling Key Factors in Financial Planning • Resources • Goals • Time Horizons • Rick Capacity • Risk Tolerance © 2012 Upside Risk Corporation. All rights reserved.
- 18. Risk Profiling Risk Parameters in Achieving Desired Outcomes • Risk Required How much risk do you need to take • Risk Capacity How much risk can you afford to take • Risk Tolerance How much risk do you prefer to take © 2012 Upside Risk Corporation. All rights reserved.
- 19. Perception of Risk Perception of how “risky” something is often determined by how readily examples come to mind from memory. Bias occurs when probability assumptions become inflated by recent events. US AIRLINE INDUSTRY PASSENGER REVENUES 1999-2004 © 2012 Upside Risk Corporation. All rights reserved.
- 20. PART IV: Best Practices © 2010 Upside Risk Corporation. All rights reserved.
- 21. “Mind the Gap” in ERM Upside Risk analysis of common human factors found in subprime related securities class action lawsuits: 1. Perverse compensation and incentives structures 2. Lack of policy enforcement 3. Inadequate internal controls 4. Conflicts of interest / Breach of Fiduciary Duties 5. Short-term focus on high risk growth strategies Source: http://securities.stanford.edu/litigation_activity.html © 2012 Upside Risk Corporation. All rights reserved.
- 22. Governance, Risk & Compliance Plan of Action to Mitigate Behavioral Risks 1. Pre-employment risk assessment to identify right and wrong “type” of people 2. Incorporate risk requirements into job descriptions 3. Design and deliver risk training and leadership development programs 4. Develop financial incentive structures that reward fulfillment of long-term business objectives 5. Create compliance program that rewards adherence to policy and punishes non-compliance 6. Enforce risk and compliance policies 7. Monitor and benchmark behavioral change (quarterly) © 2012 Upside Risk Corporation. All rights reserved.
- 23. Blind Spot Assessment Key Risk Factor Category Risk Exposure Judgment Bias Sample Size Bias Probabilities and Statistics Low Base Rate Bias Probabilities and Statistics Very High Conjunction Fallacy Probabilities and Statistics Very High Gamblers Fallacy Probabilities and Statistics Very Low Overconfidence (Perception) Behavioral Bias High Time Discounting Behavioral Bias Very High Overconfidence (Actual) Behavioral Bias Moderate Confirmation Bias Behavioral Bias Low Illusion Of Validity Behavioral Bias Very High Status Quo Bias Behavioral Bias Very Low Herding Behavioral Bias Moderate Framing Effects Behavioral Bias Moderate OVERALL High Risk Appetite Status Quo Choice Dilemmas High Sunk Cost Loss Choice Dilemmas High Sunk Cost Gain Choice Dilemmas Low Perception Investment Decisions Low Benefits Investment Decisions Moderate Behavioral Bias Investment Decisions Moderate Willingness to Pay Risk vs. Reward Very High Low Stakes Lottery Choice Moderate High Stakes Lottery Choice Moderate OVERALL High © 2012 Upside Risk Corporation. All rights reserved.
- 24. Blind Spot Assessment 0.80 0.70 0.60 Judgment Bias John Doe 0.50 Sample Population 0.40 0.30 0.20 0.20 0.30 0.40 0.50 0.60 0.70 0.80 Risk Appetite © 2012 Upside Risk Corporation. All rights reserved.
- 25. Predictive Analytics 0.80 0.70 A 0.60 B Judgment Bias C 0.50 D E F 0.40 Sample Population 0.30 0.20 0.20 0.30 0.40 0.50 0.60 0.70 0.80 Risk Appetite © 2012 Upside Risk Corporation. All rights reserved.
- 26. Tyler D. Nunnally, Founder & CEO Upside RISK Atlanta, Georgia U.S.A. Phone: +1.404.320.6047 Email: tnunnally@upside-risk.com www.Upside-Risk.com © 2012 Upside Risk Corporation. All rights reserved.