FEATURE | SMALLER FUNDS CAN SUCCEED BY MITIGATING COGNITIVE BIAS To Err Is Human, but Smaller Funds Can Succeed by Mitigating Cognitive Bias By Bruce Curwood, CIMA®, CFA® he evolution of investment manage­ 2. 2000–2008: Acknowledgement, where Diversification meant simply expanding the ment has been a long and painful plan sponsors discovered the real portfolio beyond domestic markets into T experience for many institutional meaning of risk. less­correlated foreign equities and return plan sponsors. It’s been trial by fire and 3. Post­2009: Action, which resulted in a was a simple function of increasing the risk learning important lessons the hard way, risk revolution. (more equity, increased leverage, greater generally from past mistakes. However, foreign currency exposure, etc.). After all, “risk” doesn’t have to be a four­letter word Before 2000, modern portfolio theory, history seemed to show that equities and (!@#$). In fact, in case you haven’t noticed, which was developed in the 1950s and excessive risk taking outperformed over the there is currently a revolution going on 1960s, was firmly entrenched in academia long term. In short, the crux of the problem in our industry. Most mega funds (those but not as well understood by practitioners, was the inequitable amount of time and well­governed funds in excess of $10 billion whose focus was largely on optimizing effort that investors spent on return over under management) already have moved return. The efficient market hypothesis pre­ risk, and that correlation and causality were to a more comprehensive risk management vailed along with the rationality of man, supposedly closely linked. strategy, also known as enterprise risk grounded in sound economics. The tools management (ERM), with very positive within the investment industry were some­ The wake­up call came during 2000–2008, results. Will smaller funds be able to over­ what basic. The personal computer was just when returns mean­reverted to their his­ come the governance gap (fewer resources, coming into vogue, and variance, standard torical average and investment funds shud­ lack of scale, etc.) and cognitive biases to deviation, and correlation were the key dered under the weight of three disasters adopt these new risk­managed approaches? measures of risk. Most funds used asset­ in one decade: the “tech wreck,” the global Or will apathy, inertia, and herding prevail liability modeling and some Monte Carlo financial crisis (GFC), and the European such that smaller funds continue to invest theory in conducting their annual or tri­ debt crisis. As equities fell nearly 50 per­ as they have in the past, concerned more annual asset allocation exercises. Sponsors cent during the GFC and most assets with with asset returns than meeting liabilities focused on their assets (not their liabilities), any credit exposure were also negatively or their primary goal? Risk management and the spotlight centered on the average impacted, investors had few places to hide is now firmly ensconced in the recent forecasted return rather than the full range to avoid the market downdraft other than investment literature. But knowing the of possible outcomes, perhaps anticipating government bonds and gold. Normal stan­ right answer and implementing the best an occasional one­ or, at most, a two­stan­ dard deviation and correlation were fully approach are two very different things, so dard deviation temporary setback, in an exposed as unstable, inconsistent, and of this article will focus on overcoming inves­ ever­rising equity market. Tail events were limited value in a stressed environment. tor irrationality by mitigating cognitive largely ignored, with most additional effort Pension surplus in the United States fell bias. Keep in mind that theory and practice concentrated on adding value through from 130 percent in 2000 to less than seldom align, and viewpoints vary at any active management, and tracking error 85 percent in 2008, and endowments gave one time about the best approach, resulting denoted the main measure of active risk. back most or all of their cumulative gains. in leads and lags in behavior. Capital markets were nevertheless favorable Investment results were similar around the and equities well­rewarded throughout this world. In fairness, after the first calamity An Historical Perspective on Risk timeframe, with only brief downturns. You some funds tried to diversify into alterna­ Risk management has evolved through often saw articles with titles like “Why Not tives (hedge funds, private equity, infra­ three noticeable periods since 1980: 100% Equities?” Academics and practi­ structure, and so on), but they forgot about tioners alike tended to treat investments as a the three deadly portfolio sins: leverage, 1. Pre­2000: Acceptance, where risk was science (e.g., physics, subject to natural law) illiquidity, and the lack of transparency in largely ignored. where quantitative analysis was king. many derivative products. These sins mag­ 32 INVESTMENTS&WEALTH MONITOR © 2014 Investment Management Consultants Association Inc. Reprinted with permission. All rights reserved. FEATURE | SMALLER FUNDS CAN SUCCEED BY MITIGATING COGNITIVE BIAS nified embedded market risks. Then, as our Since 2009 and the perfect investment becomes less stable), and co­variation economic and banking systems teetered, storm, a plethora of books on risk manage­ (trading flows matter), better explain the the majority recognized the true meaning ment and behavioral science have detailed complex dynamic world we live in and the of proper portfolio diversification and the the lessons learned. A variety of new and effect of irrational investors on the markets. benefits of risk management. In short, interesting investment solutions have been Therefore changing peoples’ views and out­ investors realized that the global economy generated (risk parity, dynamic asset alloca­ dated practices are a large part of the solu­ is a complex, tightly coupled, nonlinear tion, defensive equity, liability­responsive tion, which means behavioral science is system that is turbulent and nearly impos­ asset allocation, liability­driven investing, also an important prescriptive element. sible to predict, and that equities and vari­ goal­oriented investing, etc.) and more reli­ Larger institutional investment funds have ous risky assets could underperform for able tools have been utilized (e.g., condi­ seen the light and have taken action, and a prolonged periods. There are just too many tional Value­at­Risk, multi­factor analysis, risk­management revolution has taken variables to consider, including investors’ stress testing, scenario analysis, and cash hold, with corresponding changes in gover­ emotions. People are often irrational, so flow and liquidity reviews). Computer nance to limit cognitive error. the markets can be irrationally exuberant, capabilities advanced tremendously and leading to bubbles and crashes. There are investors were willing to admit to their foi­ Since 2008, fund fiduciaries have realized the business cycles, credit cycles, market bles and acknowledge the limitations of the limitations of past practices and the need to cycles, and yes, even cycles of market bub­ human mind. They realized that sometimes change their approaches to investments by bles (investor optimism becomes euphoria, they needed to be protected from them­ taking remedial action. Very little is straight­ followed by disillusionment, ending in selves. A renaissance in thought process forward in the world of economics because it panicked losses). Economics fundamen­ took hold regarding risk management and is often governed by emotion. Attempts to tally underlie market movements, but mar­ behavioral finance finally came of age. In make the profession more of a science than kets can be easily overwhelmed by fear and addition, many recognized that being more an art have floundered on the rocks of a con­ greed. We quickly understood that market forward­looking than historically focused stantly changing world that undermines eco­ risk was not stable over time and that in our investment approach was far more nomic models and makes forecasting hazard­ investors’ risk tolerances were subject to beneficial. Past deficiencies in risk manage­ ous. Many mega funds have adopted better, dramatic change, which exacerbated the ment and distorted incentive systems more prudent, risk­management and gover­ predicament. So trying to solve the risk clearly pointed to poor board oversight in nance processes and started to consider the riddle with a simple, two­dimensional the prior periods. Regulators entered the impact of human behavior on investment (mean­variance) optimization tool fray and saw risk policy as the primary duty decision making. This requires a new designed for normal markets wouldn’t of the board in any organization. The dom­ approach to risk management and gover­ work (see appendix 1). Risk­return inant theme in the literature, however, is nance. We’re not talking about structural tradeoffs were needed, along with an eval­ that good risk­management policies and tweaks. We are talking about the hard work uation of the multi­dimensionality of risk, effective fund governance are intertwined of building a better risk­management frame­ which required better tools and insights. and risk is a multi­dimensional process work and collaborative organizational culture From a macro perspective, Stultz (2009) requiring various diagnostics, both quanti­ to overcome cognitive bias. This is why we summed up