Behavioural Finance by sanmelody


									Behavioural Finance for
  Pensions Actuaries

                 Arthur Els
               11 October 2010
How many new CERA’s over past year?
Behavioural Finance for
  Pensions Actuaries

                 Arthur Els
               11 October 2010
With thanks to:

•   Human traits
•   Scheme design
•   Service providers
•   Members/Trustees
•   Conclusion
1. Human Traits
We humans have built-in biases
 •   Anchoring
 •   Loss aversion
 •   Regret avoidance
 •   Framing
 •   Hindsight bias
 •   Rules of thumb
Human Traits - Anchoring

 No of new CERA’s = 195

 Anchors =

         80      310
Peer pressure – how we eat!

• Alone
•2                  +35%
•4                  +75%
• 7+                +96%
Emotions are a MAJOR factor
Pensions Actuary: Your fund
 membership has all the following:

                     But mostly:
Human Traits - Conclusion
Your fund members are subject to:
  • Bias
  • Fear
  • Manipulation

As Pensions Actuaries, we need to
 care for them!
2. Scheme design
Scheme Design - 1

1. Never underestimate the power of
2. Greater the choice, less the
   chance of member choosing
3. Take care when communicating to
   members (“framing”)
Which is longer?

     Identical but perceived differently!
Scheme Design - 2
4. Member’s attitude to risk:
 •   Increases with frequency of
 •   After a loss, often becomes reckless
 •   Markowitz – 50/50 – “to minimise
     future regret”
Scheme Design - 2

5. Members (and we) have
   less self-control than
6. Pain from a loss >>
   pleasure from a gain
  Pensions Actuary (us – aloof)


We need to be involved -
understand the biases, fears
of our clients!!!
Scheme Design – Conclusion

Good scheme design:
 • Applies “Libertarian Paternalism” i.e.
   allow choice but nudge in right direction
 • Has sensible default portfolios
 • Caters for member biases, inertia

 • Minimises member regret

3. Service providers
Service Providers - 1
• 2006 Harvard University research for a
  major lender in South Africa:
  “By American standards the interest rates
  being offered were high – between 7,75%
  and 11,75% per month – though in line with
  the South African market”
• Embarassing!
  *Ref: Why we make mistakes Page 101
Service Providers - 2

The quandary facing service providers:
  “Despite all their virtues, markets often
  give companies strong incentives to
  cater for (and profit from) human
  frailties, rather than try to eradicate
  them or to minimise their effects”*
  *Ref: Nudge Page 73
  Service Providers - 3
Examples of exploitation by service providers:
• Anchoring – “Buy 4 and get …”
• Inertia - Sell gift vouchers that are
   never redeemed.
• Peer pressure – “Everybody else is …”
  Service Providers - 4
Exploitation in retirement funds:
• Greed – “Come to us – we choose best of
  breed of manager so that ….”
• Availability bias – “Remember the recent
  credit crisis? - our structured product fund is
  what you need…”
• 1st impression – ….
Two politicians – Who is more competent?

 Most choose him

      Princeton University study
  Service Providers - 5
Exploitation in retirement funds (ctd):
• 1st impression –
  – A good 1st impression often decides the issue!
  – Service Providers use this power to exploit funds
• Lack of financial discipline – “With our daily
  unit pricing you can trade frequently and
  make a fortune ….”
Effect of frequent trading*
• Bull market in 1990’s
    Average US Market Return    17,9%
    Return of frequent trader   11,4%
    “Gain” from frequent        (5,5%)

• Frequent traders are overconfident of
  own abilities – leading to losses
     * Wall Street Journal
 Service Providers - 6
Smoothing of investment returns:
  • PFA does permit smoothing [S14B(1)(b)]
     “…, provided that the board may elect to smooth the
      fund return”
  • Is appropriate in some funds e.g. blue-collar
  • Beware of advice to contrary from purveyors of
    daily unit pricing systems, guaranteed funds.
 Service Providers – Conclusion
1. Service providers are out to make a
2. Protect your client against exploitation
3. Are these service of real value:
  a) Daily unit pricing?
  b) Many portfolio choices?
  c) Ability to trade often?
4. Members/Trustees
Members/Trustees - 1

Powerful drivers:
1. Regret aversion – someone else is
   to blame!
  Regret is more than being sorry – it is
  feeling responsible – thus to be
2. Regret aversion (ctd)
Warren Buffett’s biggest mistake:
1993: bought Dexter Shoe Company
    a) “One of best managed companies we have seen
       in our lifetime” (Buffett)
    b) Paid $433m, issued 25 203 Berkshire shares
    a) Value of: Company ?, Shares $3,5bn
    b) “To date Dexter is the worst deal I have made. I
       gave away 1,6% of a wonderful business …. to
       buy a worthless business” (Buffett)
Members/Trustees - 2

Some powerful drivers:
2. Hindsight bias – member wears rose-
   coloured glasses when recalling own
   past actions

  Genuinely believes the rose-coloured
  view occurred!
• Picasso – “The Dream”
• Sold for $139m 29.9.2006
• Following day holed by Steve
  Wynn’s elbow
• Insurance claim for $54m
• His recollection: “I just turned
  and said …’How could I have
  done that?’”
• Observer’s recollection: “#@$#,
  Look what I have done!”
Members/Trustees - 3
2. Hindsight bias (ctd)
After recent credit crisis, some members:
   a) “Recall” giving instruction to invest in
      money market, but no record found
   b) Have taken funds to Adjudicator because
      not warned about pending crisis!
Members/Trustees - 4

Some powerful drivers:
3. Endorsement – Member assumes default
   portfolio has Trustee endorsement - thus
4. Apathy – Only 18% of those receiving
   information act on it
Members/Trustees - 5

Some powerful drivers:
5. Myopic loss aversion – Concentrating on
   short term volatility rather than long-term
6. Loss aversion – Becomes risk taker in
   order to recoup losses
Gambled bank assets in order to recoup losses

• Societe General Rogue Trader, Jerome Kerviel
• Sentenced to 3 years, must repay Euro 4.9 bn
Members/Trustees - Conclusion
 The Pensions Actuary must
   understand that Members are:

• Subject to powerful sub-conscious biases
• Emotional beings
• Fearful of making a loss
• Are capable of taking inappropriate risks
5. Conclusion
Dear Pensions Actuaries:
Giving financial advice is more
 than just cold figures

You are dealing with real people

There is a behavioural aspect to
 financial advice – understand
 this and become involved
This is an exciting extension to
our work –
       enjoy it and make a
Arthur Els
Thank you!

To top