Friday, October 31, 2008

We're all prey to dumb fashion trends

Oct 31, 2008

By Andy Ho
THE educated folk who invested in DBS High Notes 5 or Lehman Minibonds are upset. The banks and brokerages are saying this group is not among the 'vulnerable', like the elderly and less-educated, who deserve to be compensated.

According to the Department of Statistics, only 10 per cent of households in Singapore earn $200,000 or more annually. We might assume these are the 'non-vulnerables'. The average household income is about $65,000. We might then assume those earning that or less are among the 'vulnerables'.

Middle-aged, vulnerable wage earners would have taken years to save $50,000 - the sum many of them sank into the doomed products. Their children may just be about hitting that tertiary education age and its associated expenses. These workers have little time left to replenish their savings.

Younger professionals may have lost savings that would have gone towards that first Housing Board flat. And the recession may see many lose their jobs too.

These investors, including the non-vulnerable, may now feel like mugs. But the industry too should have known what precisely it was hawking right there in the bank foyer - complex, opaque, highly risky financial products.

Financial institutions say investors should take responsibility for themselves. But not every investor can understand these complex mathematical creations or the arcane legalese of their prospectuses. Even someone with an MBA or a PhD in finance might be flummoxed.

The industry bandies about terms such as 'risk' and 'returns' to rationalise why 'sophisticated investors' - the non-vulnerables - need not be compensated. But the fact of the matter is, few can make perfectly rational investment decisions consistently - and that includes financial professionals too. We are all subject to what are called 'cognitive biases'. Psychologist Daniel Kahneman won the Nobel Prize in economics in 2002 for his seminal work in this area of behavioural finance.

Cognitive biases can hit everyone equally - the non-vulnerable as much as the vulnerable investor. Sophisticated institutional investors such as mutual fund managers, insurers, actuaries and accountants are equally handicapped.

Examples of cognitive biases include:

# Over-confidence - we attribute higher earnings to companies that consistently understate their predicted earnings;

# Over-optimism - we underestimate the likelihood of fraud, often because of our faith in regulatory oversight;

# The 'availability heuristic' - or simply put, the tendency to pay more attention to recent trends, like the long bull run, and less to low-likelihood but high-risk possibilities, like the Lehman collapse;

# Susceptibility to fads - from the tulip bulb mania of the 16th century to the securitisation mania of the 21st. History is chock-full of examples of our susceptibility to dumb fashion.

Such biases can lead investors into making peremptory decisions, even when a lot is at stake. They don't maximise their use of all available information. Instead, they just 'satisfice' - or 'satisfy' plus 'suffice'- so their eventual choices are often sub-optimal. The rational actor model that economics assumes as the norm - that individuals always maximise their interests - doesn't always, or even frequently, hold true in real life.

The same goes for the assumption that capital markets are efficient, and thus always price fairly. Or that market competition ensures that banks that mis-sell financial products will pay the price in having less business. All such assumptions assume the universality of the rational actor model.

The financial industry can and does exploit our cognitive biases. This would be true even when investors in complex instruments do make money. As a wit once said: 'Not all biases apply at all times and in all settings to all investors.'

Research shows that the way consumers buy financial products is greatly influenced by not just product type, but who sells them. I buy a can of tuna at the corner store, consume it and have no further relationship with the store. Not so with retail financial products. I must be confident the bank I purchased the product from would still be around five years hence, when the instrument matures.

So the bank that sells me a complex product will continue to have a relationship with me. Even before I agree to a deal, I must trust and have confidence in the bank. I depend on its reputation.

But we now see that banks may have engaged in predatory selling, or mis-selling. This can happen everywhere. As a 2002 report by the British regulator, the Financial Services Authority, noted, there can be 'serious discrepancies between consumers' recollections of discussing risk and what financial advisers say'. A 2004 study in the International Journal of Bank Marketing confirmed that expert and lay investors can perceive financial risks in significantly different ways.

The bulk of customers buying complex financial products are repeat passive buyers, according to a study published in the Journal of Services Marketing last year. Most of them feel they don't know how to tell a good financial product from a bad one. Faced with a proliferation of products, they can't compare them effectively. They fall back instead on the reputations of their banks.

Thus, it is not surprising that most buyers of complex instruments are passive investors, unlikely to switch banks. As such, at most times banks have little incentive to address such cognitive biases, in themselves or in their customers - until, of course, a major crisis strikes and they have angry investors on their hands.

Like now.

That is when what is called 'reputational risk' kicks in: In order to salvage their reputations and preserve future business, banks may do their utmost to assuage angry investors.

What about the individual investor? How can he cope with his cognitive biases? The short answer is, not very well. To save face, many investors may in fact prevent themselves from learning from their own mistakes. They may attribute their losses to chance rather than to defective decision-making. Gains, of course, are the product of their superlative investment skills.

Given our inherent incapacity to calculate risks precisely, perhaps only those who can bear the potential financial losses - like the top 10 per cent of households - should buy complex financial products. The rest of us may want to stick with fixed deposits and government securities. And next time, be wary of financial institutions bearing gifts.

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