Financial Plans and "Flexibility"

We can learn a lot about improving our financial plans and the financial plans and advice we give our clients from Leo Tolstoy and Robert Burns.

War and Peace – The Novel

In Tolstoy’s view (extensively expressed in the novel) history was not created by great men or significant events. Rather history was the result of the interaction of millions of individual chains of cause and effect too small to be analyzed independently.The principle “great men” in the novel, Napoleon and Czar Alexander, may have believed they were in charge of their destiny but in fact they were caught up in the same web of circumstance as the rest of us.

In addition, Tolstoy emphasized the irrational motives for human behavior and hence the total unpredictability of unfolding events.  A central premise of the novel was that Napoleon never intended to invade Russia but was drawn into it and did not comprehend the forces that led him to do so.

Tolstoy linked wisdom not to innate logic or reason but to an acceptance of the foregoing state of affairs.  In Tolstoy’s view General Kutuzov, the leader of the Russian forces opposing Napoleon’s invasion, emerged as a great leader not because he developed a logical battle plan and then demanded that everyone follow it as events unfolded.  Rather, Tolstoy explained, Kutuzov’s genius lay in the fact that he was willing to adapt to the flow of events and think on his feet. In General Kutuzov’s experience each stage of a battle turned out to be vastly different from what was expected (by everyone). Based on his experience Kutuzov devised very flexible battle plans and allocated his resources accordingly.  Kutuzov often slept through battles after they began, leaving to his lieutenants the ability to react to changing circumstances. Kutuzov eventually defeated Napoleon.

Well I don’t recommend that you go to sleep but I do recommend that you “be (Tolstoy) wise” and accept the fact that you cannot predict what will happen in the future (both in the markets, in your personal lives  or those of your clients).  Build in flexibility to your financial plans and the advice you give your clients.  Then you can be a modern Kutuzov.

My point:

Don't build a plan based on an anticipated future and then change the plan when the future does not turn out as anticipated. Build your plan to take as many contingencies as possible into account.  It's the difference between a great plan and an ordinary plan - between winning and losing.

Robert Burns, the national poet of Scotland wrote a poem which eloquently describes our human dilemma.  I reproduce a part of it below.

“To a Mouse” by Robert Burns

"But, Mousie, thou art no thy lane,
In proving foresight may be vain;
The best-laid schemes o' mice an 'men Gang aft agley,
An'lea'e us nought but grief an' pain,
For promis'd joy!

Still thou art blest, compar'd  wi' me
The present only toucheth thee:
But, Och! I backward cast my e'e.
On prospects drear!
An' forward, tho' I canna see,
I guess an' fear!"

Behavioral Finance and Economics- Comparatives

People are funny in many ways. Here is one which may be of interest to you.  We can’t decide if we want something unless we see it in a comparative context.  We have a compulsive desire to compare before deciding.  We want to compare things that are easy to compare. On the other hand we dislike (and avoid) comparing things that are not compared easily. Marketing folks know this tendency all too well and manipulate us with it.  For example take the three levels of gasoline at the pump. Depending on underlying conditions (such as supply and profit margin on each octane) the price spread is sometimes altered to have two closer in price. That price spread then gives us an impulse to buy one of two octanes (not uncommonly the highest priced gasoline and if not then the second highest price gasoline).   Another example occurs frequently in a men’s store when shopping for ties¹.  They inevitably bring out three ties, two basically red and one blue.  The vast majority of us will select one of the red ties.  Reverse things and we will pick a blue one.  Marketing folks insert a third choice in our selection and purposely make the third choice similar to one of the other choices but slightly inferior in terms of value.  This choice is actually called the “decoy” in marketing circles.
   
This propensity is a good example of the operation of a judgmental heuristic or mental short cut.  It is also a reflexive (and not a reflective) mental process.

You may wish to consider the foregoing in the future in managing your risk². 

1.  This does not apply when women are looking at shoes in which case no marketing techniques are necessary.  There is no truth to the rumor that "must buy shoes" is a subliminal message sent out over "muzak" in the women's shoe department of Nordstrom.
 2.  In July 2008 an Organization called The Edge Foundation, Inc. held a symposium taught by three preeminent scholars in Behavioral Economics, Richard Thaler, Sendhil Mullainathan and Daniel Kahneman (the winner of the 2002 Nobel Prize in Economics). The attendees included founders of firms such as Amazon and Google. The symposium lasted several days with a seminar on one topic presented each day. The seminar on the first day was presented by Dr. Thaler on the topic of "Libertarian Paternalism: Why it is impossible not to nudge". A quote from Dr. Thaler in this symposium sums up his message: "If you remember one thing from this session, let it be this one: There is no way of avoiding meddling. People sometimes have the confused idea that we are pro meddling. That is a ridiculous notion. It's impossible not to meddle. Given that we can't avoid meddling, let's meddle in a good way." Along with Cass R. Sunstein, Dr. Thaler is the author of a book entitled: Nudge: Improving Decisions About Health, Wealth, and Happiness.

The Evolution of the Customer Complaint - Portfolio Evaluation Tools

Since 1979 the financial services industry has been undergoing a paradigm shift from transactional business to what is called managed money. That shift has accelerated within the last few years. Most full service firms today engage in managing assets far more than in transactional business. The dramatic rise in the popularity of the Registered Investment Advisory firm (to say nothing of the hybrid firms now being created) only confirms this trend.  True transactional business is alive and well, primarily with online discount houses. There will always be a small portion of the business that will be transactional in nature but the lion’s share going forward will be in asset management.

On that basis I think we can safely expect that customer complaints and arbitrations in the future will focus on the acquisition and maintenance of an investment portfolio. This focus may be on the portfolio itself or its components. Therefore, I believe that virtually everyone associated with the financial services industry should develop a working knowledge of what can be loosely characterized as portfolio evaluation tools. If you are an investor you should also become acquainted with them as well, whether you pick your own investments or let someone else manage your assets. I have composed a short list to get you started.*

You may wish have to have some familiarity with:

Standard Deviation – in the financial services industry, a measure of systematic and unsystematic risk of an investment or portfolio.

Beta – a measure of the volatility of a stock or portfolio against a benchmark index.

R-squared – a statistical tool used to determine the relevance of Beta.

Alpha (Jensen Index) – a tool to measure the risk adjusted performance of a diversified portfolio.

Sharpe Index or Ratio – a tool to measure the risk adjusted performance of an undiversified portfolio.

Sortino Index – a modification of the Sharpe Ratio using downside variance only.

Treynor Index – another tool to measure the risk adjusted performance of a diversified portfolio.

Duration – a tool useful in measuring the volatility of bonds versus changes in interest rates.

Value at Risk - a tool that calculates the maximum loss expected (or worst case scenario) on an investment, over a given time period and given a specified degree of confidence.

You may also wish to be familiar with the interrelationships some of these tools have (e.g. R-squared and Beta).  I don’t think that you necessarily have to know how to do the actual calculations but rather have sufficient familiarity to know the appropriate circumstances for the use of a particular tool and the significance of the results of its application.

Google is a good place to start your education.

*For the brokers reading this, I know you know this material already; however, many other persons associated with your industry (including your clients) do not and should.  For those of you in the dispute resolution business these tools add new dimensions to concepts such as suitability or the nature and extent of a duty owed to the client.

Behavioral Economics and Finance - What do we mean by Risk Tolerance

What do we really mean when we say “risk tolerance?”

Discussion about the suitability concept in the regulation of securities transactions frequently focuses on the “risk tolerance” of an investor/client.  If risk tolerance is defined on a subjective basis, that is, what is the actual psychological risk tolerance of this client and not what should it be (the objective basis) then perhaps the risk tolerance would change depending on changes in the mental outlook of the client^*. If that is the case …

*   I googled “define risk tolerance” and came up with an abundance of definitions. Of those which addressed the definition in the context of investing I would estimate that a slight majority simply assumed a subjective orientation and the remainder addressed it in terms of an objective standard.  Not one addressed this issue head on.  There are many scholarly articles which recognize the distinction and suggest ways to overcome an “inappropriate level of risk aversion” (or subjective risk tolerance) but they do so in connection with an analysis of the acquisition and maintenance of an objectively appropriate portfolio and do not discuss the issue at hand. I suggest that the question I posed at the beginning of this Observation is important and especially so in the context of dispute resolution.

…then what follows may be important.

·        Paul MacLean

            Please excuse the length of this Observation.  In past Observations I have identified certain components of the brain and discussed how the brain uses them to confront and resolve economic dilemma.  I would like to dig just a little deeper on this subject because I think it is critical to have a basic understanding of brain anatomy and function if you are to separate yourself from the pack.  So with that here goes….

The era of the development of classical economic theory took place before the development of modern neurological science and theory.  Economists (and others) during that era believed that the cognitive portions of our brain dominated the non cognitive portions of our brain thus controlling our economic behavior.  This belief may have helped to develop two assumptions which underlie much of what we learned about economics and finance. The first assumption is that people make rational economic decisions (think of the concept of utility maximization). The second is that people are unbiased in their predictions about the future.  The utilization of these assumptions probably reached a culmination in the 1950's when Harry Markowitz presented the concept of the "efficient frontier" in connection with what has become known as "Modern Portfolio Theory."

    Over the succeeding decades neuroscience began to demonstrate that which we already knew and that was that those two assumptions (while probably useful in the abstract) were simply and fundamentally wrong¹.  Let me explain.  In 1970 Paul MacLean, a neurologist proposed a (then) novel concept and that was that we have in effect three brains (not one) each with a separate evolutionary chronological history.  Each subsequent brain was built around (indeed to an extent physically wrapped around) and upon the foundation of the brain or brains that preceded it in evolution.  MacLean called this the "triune brain."² His classifications of the brains were (1) the reptilian (consisting of the brain stem and cerebellum), (2) the limbic or paleo - mammalian brain and (3) the neo-mammalian brain (the cortex). These three brains operate much as "three interconnected biological computers, [each] with its own special intelligence, its own subjectivity, its own sense of time and space and its own memory".  Each brain is connected by neural pathways to the others, but each operates as its own brain system with distinct capacities. Further work by MacLean and others have shown that the cortex often does not dominate the other brains but is often overruled in the evaluation and decision making process (frequently by the older limbic system-the one that rules emotions)³.

The first to develop in evolution is the reptilian brain possessed by all animals. It is ancient, basic, rigid and functionally repetitive.  In sum it regulates our involuntary muscles and basic bodily functions such as our breathing and heartbeat.

The second is the Limbic system or for lack of a better description the middle part of our brain.  This portion is possessed by most mammals. It is concerned with regulating emotions and instincts and largely is responsible for our survival from harm.  It includes the hypothalamus, hippocampus, and amygdala.  This system determines, among other things, whether you will have a positive or negative outlook in regard to something and is responsible for your determination of the "relevance" of something you encounter. It also is involved in your determination as to whether the cortex has had a good or bad idea.  The limbic system has vast interconnections with the cortex, so that many brain functions are not either purely limbic or purely cortical but a mixture of both. That, it turns out, is a very important point. Often the Limbic system overrides a conclusion by the cortex.

The cortex and the last "brain" to develop is the seat of cognitive functions and rational thought. It was exclusively here that classical economists thought that economic dilemma were confronted and decisions made.  It turns out not to be the case at all. In previous Observations I have discussed those portions of the brain that are involved and their effect on the evaluation and decision process. If you didn't receive them I can send you a copy.  More importantly, there are many good books and articles dealing with this subject and I would suggest googling "neuroeconomics", "behavioral economics" and "behavioral finance" as a way to find them.

Oh yes, what's my point in all this? Learn the basics of this new body of knowledge and beat out your competitors. 

1. Do you really think that a real live investor’s risk/reward parameters can be described using a quadratic utility function? 
2. Paul D. MacLean, A Triune Concept of the Brain and Behavior: The Clarence M. Hincks Memorial Lectures, 1969, University of Toronto Press, 1973. ISBN 0-8020-3299-03. Paul D. MacLean, The Triune Brain in Evolution: Role in Paleocerebral Functions, New York: Plenum Press, 1990.ISBN 0-306-43168-8.
3. See for example Paul W Glimcher, Decisions, Uncertainty, and the Brain: The Science of Neuroeconomics (Cambridge, MA;MIT Pres, 2003) and Colin Camerer, George Loewenstein, and Drazen Prelec, “Neuroeconomics: How Neuroscience Can Inform Economics,” Journal of Economic Literature 32 (2005):9. For those who prefer to read informative but less academically oriented works, Jason Zweig’s book is a good start