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Risk and human bias

Risk managers are being advised to take more notice of the human element when investing in the financial markets and economic theory cannot truly work unless it incorporates human emotional traits, according to research conducted by Investor Analytics and BNY Mellon Alternative Investment Services'.

Their white paper discusses the growth of interest in behavioural economics, cognitive studies and complexity science within finance, and how it impacts on a firm's risk strategy.

It concludes that risk strategies will have to constantly evolve to keep up with market developments, and will not be able to subscribe to traditional economic theory because they need to acknowledge the human factor.

The paper suggests that the low acknowledgement of human biases within decision-making makes it difficult for risk strategies to be achieved because individuals' biases can regularly alter the course of that strategy and affect others in the meantime.

The paper, authored by Damian Handzy, CEO at Investor Analytics, claims that trying to understand whether economic theories would work is indeed "not rocket science" but "much harder than rocket science" because it ought to take into account the behaviour of those people making the key decisions.

Handzy argues that five types of bias in behavioural economics - framing, representation, overconfidence, anchor bias and loss aversion - should be included within the formulation of a risk management strategy. He says what individuals think to be the result of their actions can often turn out to be the opposite, and patterns an individual might believe they can see may not in fact exist:

• Framing bias means individuals will react either positively or negatively according to framing, for example when a medical procedure is described as having a 1% mortality rate or a 99% success rate;
• Representation bias: when presented with a choice between a summary scenario and a more descriptive one, people are more likely to opt for the descriptive scenario even though they are in fact statistically less probable, because people have a natural bias towards believing stories with more detail;
• Risk managers are likely to be overconfident in their assumptions and strategies for hedging risk, while the search for market efficiency and rationale is unlikely to be found because neither can actually be achieved;
• Anchor bias is likely to mean a person's decisions could be influenced by something totally unrelated, such as the price of an item recently purchased or a telephone number just dialled;
• Risk aversion leads individuals to display opposing risk tendencies and they are likely to be risk-averse when it comes to gains, but are greater risk takers when it comes to losses they have suffered.

Whereas many pension funds and asset owners are looking for strong theories to back up their economic and risk arguments, what should be acknowledged as the most important factor in an individual's ability to generate wealth is luck rather than skill or hard work, since small, chance events can have a significant impact on outcomes.

An interesting additional argument is that equity volatility may also be driven significantly by the rules of the exchange upon which stocks are traded, rather than the traditional view, which states that volatility is caused by a lack of information flow.

The order in which market and limit orders are filled influences the volatility and should therefore be considered when setting the risk strategy. Statistical models tend to ignore the influence of transaction costs, taxes, liquidity and other ‘friction-like' factors which are the actual cause of volatility.

Volatility is a necessary component of market activity and returns, but volatility itself does not decrease with efficiency in the markets. Any risk strategy assuming low volatility is likely to be unrealistic, as is any market analysis which assumes market rationality equilibrium and optimal behaviour, says Handzy, because the ideal is unlikely to be achieved and markets are constantly adapting to their environment.

In future, risk management will require substantially enhanced analytic metrics. Investors will have to incorporate "not just the fact that we are ‘irrational' decision makers, but the very ways in which we are irrational in making our decisions".

Visit http://www.investoranalytics.com/ content/September-15-2009 to read the paper

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