GLOBAL - Risk managers are being advised to take more notice of the ‘human' element when investing in the financial markets, as white paper research suggests economic theory cannot truly work unless it incorporates human emotional traits.

Investor Analytics and BNY Mellon Alternative Investment Services have produced a white paper discussing the growth of interest in behavioral economics, cognitive studies and complexity science within finance, and how it impacts on the risk strategy a firm or individual takes.

It concludes that risk strategies will in future 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 the low acknowledgement of human biases within decision-making makes it difficult for risk strategies to be achieved at present, because individuals' biases can regularly alter the course of that strategy and affect others in the meantime.

The paper delivered by Damian Handzy, CEO at Investor Analytics, claimed 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.

He argued five types of bias - framing, representation, overconfidence, anchor bias and loss aversion - in behavioural economics should be included within the formulation of any risk management strategy because analysis suggests what individuals think to be the result of their actions can often be the opposite, and patterns an individual might believe they can see are in fact not there at all.

Framing bias means individuals will react either positively or negatively depending on whether it is framed as a medical procedure having a 1% mortality rate or a 99% success rate. Representation bias, when presented with choosing between a summary scenario and a more descriptive one, means people are more likely to opt for the more detailed 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 a sandwich that was purchased minutes before, or by the phone number we just dialled". Risk aversion leads individuals to act out opposing risk tendencies as they are likely to be risk averse when it comes to gains, but are greater risk takers when it comes to the losses they have suffered.

And whereas many pension funds and asset owners are often looking for strong theories to back up their economic and risk arguments, what many individuals should instead acknowledge is "the single most important factor in a given agent's probability of wealth was not skill or hard work, but rather simple luck" because small chance events can have a significant impact on the ultimate outcome.

The upshot of this research is risk management will look very different in the future and require substantially enhanced analytics, according to its authors, as investors will need 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".

To read this white paper, go to http://www.investoranalytics.com/content/September-15-2009 or click on the weblink.

If you have any comments you would like to add to this or any other story, contact Julie Henderson on + 44 (0)20 7261 4602 or email julie.henderson@ipe.com

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