The Death of the Investment Policy Statement?

This article appeared in Arab Times on 19th March 2012.

For half a century, portfolio managers have been taught that the basis of every solid investment process is an investment policy statement (IPS). The 2008 financial crisis has called this view into question. Following an earlier article in the Financial Times (FTfm supplement) Kevin Terhaar, Director of Examination Development at CFA Institute, Stephen M. Horan, PhD, Head of Professional Education Content at CFA Institute, and Mandagolathur Raghu, President of CFA Kuwait  examine the role of the IPS and whether it can survive.

What is the IPS and why is it valuable?

The IPS is a document that describes the investor’s risk tolerance, return expectations and objectives, liquidity needs, and other constraints. It may be drafted in relation to either an investor’s entire financial position or only the portfolio under consideration.

Traditionally, an important part of the IPS has been the benchmark portfolio, or strategic asset allocation—what asset classes are to be included and in what proportions. Such a roadmap is best practice because it provides the investor with a foundation for setting long-term exposure to systematic risk and making decisions on manager hiring, tactical (i.e., shorter-term) asset allocation changes, and other investment implementation choices.

What is the practice in the GCC?

The GCC region is dominated by the presence of High Net Worth Individuals (HNWI), as a result of the hydrocarbon economy and the wealth generated through it in the last few decades. However, wealthy investors in the region have a two-dimensional approach to wealth management. They split their investments into local/regional and global. Given their proximity to and visibility of the local/regional markets, HNWI’s prefer to manage their investments in the region personally whilst they prefer to outsource the management of their international allocation. In general, the international allocation is guided by an IPS while the local/regional management tends to be managed reactively, though there are no firm studies to substantiate this. The approach to asset allocation also differs by geography. Given the limited range of asset classes open to investors  in the region, most of the wealth is deployed in equities (public, private and family business) and real estate while international portfolios are reasonably diversified with other asset classes especially bonds, hedge funds, commodities, etc.

Why has the IPS come under attack in the last few years?

After the tech bubble burst in the early part of this decade, a number of renowned investment pundits observed that many investors were badly served by their high-equity allocations. They believed that the solution was to de-emphasize strategic asset allocation.

What are some alternatives?

Some commentators went so far as to recommend that investors discard the notion of a benchmark entirely. The best course of action was to seek out sources of returns, wherever they might be found. 

Rather than investing according to a fixed plan, nimbleness was the order of the day. This approach was sometimes mistakenly called the “endowment model” in sales pitches, especially if it emphasized alternative assets.

What are the pitfalls of discarding the IPS?

Investors aim to maximize a portfolio’s expected return (for a given level of risk) but often find that they are thwarted in attaining this optimum by their own behavior. Behavioral finance has taught us that investors’ decision making is typically subject to biases. 

In a return-seeking setting, investors are highly vulnerable to herding behavior because when making decisions, they tend to place the greatest weight on their most recent experiences. 

How has this prescription turned out?

Combining the “IPS alternative” of searching for high returns with extrapolation of recent past market environments has proved to be exactly the wrong advice at the wrong time. A number of high-profile investment managers and funds increased equity exposure immediately before the stock market downturn.  In the case of GCC, exposure to real estate investments compounded the issue.

Likewise, as returns soured and pessimism reigned in late 2008 and early 2009, many reined in their risk by reducing equities, high-yield bonds, and other higher-risk assets. Adhering to a well-constructed investment policy would likely have produced better results. So, it is not at all clear that fund trustees and managers have the processes or the ability to capitalize on opportunities or avoid ill-advised risks.

What can be done to rectify this situation?

Rather than discarding the IPS, investors and investment committees would be better served by relying heavily on the IPS to guide their long-term investment decisions. 

Despite declarations to the contrary, many investors have quite a short-term investment horizon, especially in turbulent investment environments in which many react to losses by selling risky assets and moving to cash near the bottom. To counteract this behavior, the IPS can incorporate an investment “philosophy” and instructions that codify guidance as to how the portfolio will be managed, particularly in difficult markets. HNWI’s in the GCC region will be well advised to insist on developing and implementing an IPS by their local wealth managers just as they do with international wealth managers.

How can an investment philosophy provide guidance?

Simple portfolio rebalancing rules are very helpful in this regard. In addition, the IPS can specify ranges or boundaries at which asset weights will trigger a purchase or sale to bring the portfolio back to its strategic allocation. 

An IPS that specifies a “default” portfolio and a rigorous investment management approach may result in a somewhat contrarian investment style—one in which an investor buys assets whose prices have been knocked down because other investors are fearful and sells assets during more halcyon conditions.

Why is this sort of guidance important?

Without a framework for making asset allocation decisions, investors will find themselves adrift and more susceptible to getting caught up in the herd. The result is likely to be poor investment performance.

By adhering to a well-thought-out and well-developed investment policy, investors stand a better chance of achieving their long-term investment goals.

Behavioral Finance—Nothing New Under the Sun

This article was originally published in Arab Times

According to a recent survey, an overwhelming majority of members of the CFA Society of the UK believe behavioural analysis is a useful addition to modern portfolio theory but is insufficient to replace it. Following an earlier article in the Financial Times (FTfm supplement) Stephen Horan, CFA, head of professional education content and Mandagolathur Raghu, President of CFA Kuwait CFA discuss the role of behavioral finance in investment decision making.

The GCC stock market has for a long time depicted behavioral biases swinging between irrational exuberance and deep remorse. The speculative character of the market combined with lack of institutional investors lends itself to this problem. Retail investors in the region exhibit wild mood swings and distort valuation based pricing even during the medium term. This article aims to clarify certain recent trends in behavioral finance and how an understanding of this evolving subject can be useful for GCC investors.

What is behavioral finance?

Behavioral finance combines the classical theories of economics and psychology. In essence, it attempts to explain deviations from the standard view that economic actors make purely unemotional or rational decisions. In forecasting, for example, investors tend to be overly confident in their accuracy, place undue emphasis on recent experience, and anchor their expectations using others’ predictions. 

How long has the field existed?

It is often traced back to the late 1970s when academicians such as Daniel Kahneman, Amos Trversky, Robert Shiller, Hersh Shefrin, Richard Thaler and Meir Statman started researching investor decision making in a robust manner. As far back as 1934, however, in the first edition of Security Analysis, Ben Graham referred to investors having “unlimited optimism” followed by periods of “deepest despair.”

Around that same time, John Maynard Keynes spoke of “instability due to the characteristic of human nature that a large part of our positive activities depend on spontaneous optimism rather than on mathematical expectation.” Behavioral economists refer to this as optimism bias.

What role has behavioral finance played in the investment landscape?

The principles of behavioral finance do not lend themselves to mathematical modeling because they are typically advanced in the form of cognitive biases. Recognizing, for instance, that investors are often overconfident in their abilities does little to help them determine whether a particular asset (or the market) is over or undervalued.

Whether they are an accurate depiction of reality or not, most classical valuation and macroeconomic models are based on the assumption that investors are purely utility maximizing rational decision makers. The weakness of these models is that they often suffer from the illusion of precision. Although not suffering from the illusion of precision, at the opposite extreme, behavioral finance is extremely difficult to model.

What are the latest developments?

Recently, researchers have been using MRI technology to map the neurological reactions investors have to making a profit, suffering a loss, confirming an expectation, or experiencing a surprise. This fascinating research, called neuroeconomics, shows that reactions in the brain to some investment experiences can be similar to when an addict takes drugs or a gambler wins a bet. 

The field is also benefiting from evolutionary biology insights that help explain how heuristics, which can sometimes lead to “irrational” decision making, play a critical role in survival because they help people efficiently avoid catastrophic outcomes.

What are some remaining challenges?

Behavioral finance still lacks a set of unifying principles that tie together observations of human behavior and brain activity in a way that not only explains behavior but can also be used to model corrective action or profitable trading opportunities. 

Does behavioral finance create profitable trading opportunities?

Yes, in fact, many mutual funds exist that implement some level of behavioral finance in their investment strategies. A 2008 study of these funds in the Journal Investing, however, found that they did not generate abnormal returns during the period examined.

At its core, the discipline of value investing is largely based on behavioral finance principles. Implementing a strict value-based or contrarian investment philosophy can require exceptional fortitude, especially in volatile markets when it might be difficult to convince one’s investors’ of its wisdom.

What lessons can investors draw from behavioral finance?

Individuals can learn that they are susceptible to overreactions in both bull and bear markets. The best way to stay focused on a long-term investment strategy is to document it in an investment policy statement along with an investor’s return requirements, risk tolerance, and investment constraints. It can then serve as a useful reference in both quiescent and turbulent markets.

What are the lessons for fund managers?

First, managers might consider maintaining liquidity, limiting leverage, and creating other cushions in anticipation of possible market stress. If “irrational” investor behavior creates opportunistic mispricing, it may take considerable time to dissipate and may get worse before it gets better.

Second, even if strict behavioral finance investment strategies are not highly successful, managers might augment their existing strategies to avoid herding, overreaction, regret aversion, and other behavioral biases that interfere with their effective implementation. For example, a diverse investment committee can help to encourage fresh ideas and minimize groupthink; and procedures to measure, monitor, and control some behavioral biases can help improve decision making.