Understanding Investor Behavior and Managing Risk (Video)

The 21st Annual GIPS Standards Conference will be held 14–15 September 2017 in San Diego, California.

Dan diBartolomeo, president and founder of Northfield Information Services, discusses behavioral aspects of risk in financial markets, including how individual behavior shapes the way industry deals with risk and common risk measures that are potentially useful but often misunderstood.

During his presentation at the GIPS Standards Annual Conference, diBartolomeo discussed (at 35-minute mark in the video) “principal agent problems” that get at the relationship between investors and the agents who manage their money. He believes this has created a situation whereby most investment firms are not properly managing risk; rather, they are managing the appearance of risk (more examples discussed at the 55-minute mark) to clients and regulators. This leads to the perception that they have done everything they need to do, when in fact they have not done what is needed from a risk perspective. He noted that most investment management firms simply manage their own business risk — they want to avoid getting fired — as opposed to managing actual risk to their investors.

The regulatory environment also shapes the risk landscape of asset owners and investment managers because risk management practices are largely mandated by regulation. However, he believes many of these regulations are meant for commercial banking and do not serve the needs of the asset management industry. There, rules tend to focus too much on short-term downside and solvency risk issues that are often not appropriate for long-term asset owners. Mr. diBartolomeo’s key takeways (summarized at the 59-minute mark of the video):

• Investor understanding of risk is weak, and it lacks a well-accepted vocabulary for the more subtle aspects of risk such as short term vs. long term, risk vs. uncertainty, and the potential for bad outcomes vs. the potential for an unexpected outcome.
• There is a real lack of industry understanding of long-term investor objectives, which has led to inappropriate risk policies.
• The asset management industry is very complicated. However, in an effort to easily communicate with people, the industry has reduced the risk discussion to simple risk metrics, most of which are irrelevant.
• The financial community often fails to distinguish between observed investor behavior and appropriate investor behavior. What investors actually do is very different from what they should do; so if you are setting your investment policies to make clients happy rather than to increase their wealth, you are probably doing them a disservice.

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