Solutions to a Misbehaving Finance Industry

We live in a world with “too much finance” according to a recent report from the International Monetary Fund (IMF). The IMF finds the benefits of the finance industry to an economy fall, and the costs of volatility rise, when the sector grows beyond a particular size — a size that most of the finance industries in developed countries now far exceed.

Excessive financialization sucks in talented young graduates from more useful occupations, invents superfluously complex financial products, misdirects investment capital into bubbles, and if unchecked by effective regulation, encourages many evils. So, is this evidence of a finance sector malfunctioning so badly that it will inevitably lead to capitalism’s demise?

Gresham’s Dynamic

It has even been suggested that much of the bloated finance industry is set up to exploit the ignorance and biases of consumers. Maybe that’s taking the argument too far, but it’s worth taking a close look at “information asymmetry” — when there is a difference in knowledge about a product between its seller and its buyer. Nobel laureate George Akerlof wrote about Gresham’s dynamic in 1970 to describe circumstances where “dishonest dealings tend to drive honest dealings out of the market.” Costs of dishonesty, for example, in a used car purchase, include not only the amount the buyer is cheated of, but also “the loss in driving legitimate business out of existence.” Clearly a bad outcome for consumers and bad for society, too.

In finance, of course we don’t transact used cars, but we do transact financial services and products — products often so complex that any amount of help, even complete information symmetry, might fail to help consumers or investors take the correct decisions, or save them from their own behavioral biases.

Countering Behavioral Biases

One innovative solution to behavioral biases at the consumer level — in reality a nudge by design — is proposed by recent research from a team of University of Sydney researchers. The authors argue that the introduction of prize-linked savings accounts can generate an increase in savings, especially among households with low income. Accounts that carry a chance to “win big” are perceived as a savings product rather than gambling. Behaviorally, consumers anchor on and evaluate bundles very differently from their underlying components.

For practitioners, behavioral biases can lead to exaggerated notions of the benefits being accrued for clients, according to Charley Ellis, CFA, speaking at the 2013 Wealth Management Conference held in Calgary, Canada: “practitioners should help clients understand their true goals, use index funds whenever possible, and reduce fees to a level commensurate with the real value added.”

At the level of institutional asset owners, committees are a fact of life, just as are behavioral biases. As Arnold S. Wood, president and CEO of Martingale Asset Management, pointed out in a classic CFA Institute Conference Proceedings article, “A thorough understanding of the behavioral biases of individuals as they interact in a group, such as a committee, requires that the committee chair proactively neutralize both the behavioral and social obstacles that impede a committee’s successful achievement of its goals.”

The Power of Human Reason and Rationality

The academic discipline of behavioral finance has mined a rich vein of human frailties, yet for most investment practitioners, its 40 years of scholarship have proven a disappointment. How do we apply these arresting (and usually entertaining) insights? If we haven’t learned the lesson of how dumb we are by now, it’s hard to imagine we ever will.

Eminent German psychologist Gerd Gigerenzer has long been a thorn in the side of the preeminent behavioralist school. In fact, he was the only critic Daniel Kahneman acknowledged in his recent magnum opus on the topic, Thinking, Fast and Slow. Gigerenzer is famous for casting doubt on the behavioralists’ early laboratory research on decision theory (prospect theory), which typically presents a problem, identifies a strategy people grasp to resolve it — for example, overconfidence or anchoring — and shows them to be irrational. On the contrary, Gigerenzer suggests we are intuitively rational in our own way and not at all as stupid as you might think.

Gigerenzer argues such strategies only look bad in a lab setting because that setting strips out natural environments that, of course, deeply affect what occurs. Instead, the rationality of any strategy should be determined by its adaptive usefulness in a natural environment rather than someone’s erroneous opinion as to its rationality in a lab. In one recent paper, Gigerenzer asks, “Can the general public learn to deal with risk and uncertainty, or do authorities need to steer people’s choices in the right direction?” He concludes that nudges from above that are influenced by behavioral research are often counterproductive: we are all highly educable — people can be taught to become risk savvy with the proper instruction.

Countering Uncertainty with Long-Termism

A long investment timescale offers perhaps the greatest opportunity to dampen risk and uncertainty and mitigate a few annoying behavioral biases. At the 68th CFA Institute Annual Conference in Frankfurt this year, Keith Ambachtsheer was a big proponent of long-termism. Asset owners can leverage their longer time horizon to choose investments that will provide long-term value for their beneficiaries and also have greater positive impact on society.

In a piece for the Rotman International Journal of Pension Management and summarized in CFA Digest, Ambachtsheer condemned short-term forces as an impediment to long-term investment, which is critical for wealth creation. A proper alignment of principal-agent incentives in the political, commercial, and financial spheres is a critical factor to move from a day-to-day focus to a longer-term view. Yet as CFA Digest abstractor Louis A. Lemos II, CFA, concluded, “I am not confident that the scourge of short-termism will wane anytime soon because . . . agents do not seem to have a willingness or ability to practice long-termism in today’s increasingly complex, instant-gratification, continuous cable news, and social media–driven world.”

Related readings, including recent CFA Digest summaries and CFA Institute Conference Proceedings for interested readers to research, are summarized below:

• Seeing Investors’ Reality as Our Profession’s Reality: Practitioners in the investment industry often succumb to common behavioral biases that lead to inflated estimates of the value that is being delivered to clients, Charley Ellis, CFA, observes. To raise the standards of professionalism in the industry, practitioners should help clients understand their true goals, use index funds whenever possible, and reduce fees to a level commensurate with the real value added.
• The Case for Long-Termism: Short-term forces are an impediment to long-term investment, which is critical for wealth creation, Keith Ambachtsheer declares. When these short-term forces are moderated, implementing long-term investment strategies that generate positive long-term excess returns becomes increasingly possible.
• Long-Termism: An Opportunity Worth Seizing: The dialogue on long-termism is now extending to a new era of fiduciary capitalism, Rebecca Fender, CFA, says, one that emphasizes the role large asset owners can have — using their longer time horizon to choose investments that will provide long-term value for their beneficiaries and also have greater positive impact on society.
• Savings and Prize-Linked Savings Accounts: Drawing on results from an online experiment conducted in the United States, the authors argue that the introduction of prize-linked savings accounts leads to an increase in savings, especially among households with low income.
• Behavioral Finance and Investment Committee Decision Making: Committees are a fact of life in the business world, and managing committee dynamics to enhance decision making is a challenging task, with the responsibility for ensuring committee effectiveness typically being the purview of the committee chair. A thorough understanding of the behavioral biases of individuals as they interact in a group, such as a committee, requires that the committee chair proactively neutralize both the behavioral and social obstacles that impede a committee’s successful achievement of its goals, according to Arnold S. Wood.
• Best Practice Investment Committees: Endowment funds typically have two governing bodies: the board of trustees, which has ultimate institutional responsibility, and the endowment investment committee, which has responsibility for the fund’s investment performance. A best practice investment committee, according to Charley Ellis, CFA, ensures that the optimum investment result for the endowment is achieved by focusing on good governance.
• On the Supposed Evidence for Libertarian Paternalism: Can the general public learn to deal with risk and uncertainty, or do authorities need to steer people’s choices in the right direction? Libertarian paternalists argue that results from psychological research show that our reasoning is systematically flawed and that we are hardly educable because our cognitive biases resemble stable visual illusions. Gerd Gigerenzer concludes, however, that the notion that we cannot be taught is not supported by the evidence and “forecloses the true alternative to nudging: teaching people to become risk savvy.”

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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