CFA Society New Mexico...Fooled by Randomness: The Hidden Role of Chance in Life and the Markets....

CFA Society New Mexico

Bob SchmidtManager, Brandes Institute

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Are A & B Different Shades of Gray?

Source: Edward H. Adelson, 1995.

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Are A & B Different Shades of Gray?

Source: Edward H. Adelson, 1995.

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Prospect Theory & Framing

System 1 (fast thinking, taking short cuts)

• “operates automatically”

• “little or no effort”

• “no sense of voluntary control”

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Prospect Theory & Framing

System 2 (slow thinking)

• “effortful mental activities”

• “agency, choice and concentration”

Kahneman, Daniel. Thinking Fast and Slow. New York: Farrar, Straus and Giroux. 2013.

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Prospect Theory

Mental Value

Losses Gains

Fear = 2xGreed

Kahneman, Daniel. Thinking Fast and Slow. New York: Farrar, Straus and Giroux. 2013.

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• Grows consistently for 20 years

• Low standard deviation

The Bumble Corp. The State of Bliss

A Hypothetical Portfolio

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• Paper Gains =

1 positive emotional unit

• Paper Losses =

2 negative emotional units

How often do you look?

Chance of seeing a “Paper Gain”

Once a year 93%

Every quarter 77%

Every month 67%

Every day 54%

Every hour 51.3%

Every minute 50.17%

Every second 50.02%

Benefits of a Long-Term Focus

Source: Taleb, Nassim Nicholas. Fooled by Randomness: The Hidden Role of Chance in Life and the Markets. 2nd Ed. New York: Thomson,

2004. pages 64-68. This hypothetical example is intended for illustrative purposes only. It does not reflect the performance of any specific

investment vehicle. Actual results will vary.

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Wheel of Investor Emotion

Source: Taleb, Nassim Nicholas. Fooled by Randomness: The Hidden Role of

Chance in Life and the Markets. 2nd Ed. New York: Thomson, 2004. pages 64-68.

This hypothetical example is intended for illustrative purposes only. It does not

reflect the performance of any specific investment vehicle. Actual results will vary.

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More News = More Information?

Get Rich.com

– Time,

September 27, 1999

“Bubble Fears as U.S.

Stocks Break Records”

– Financial Times,

November 20, 2013

“Bailout Fails; Stocks Plunge.”

– The New York Times,

September 29, 2008

“The Death of Equities”

– Business Week, August 13, 1979

“The Rebirth of Equities.”

– Business Week,

March 9, 1983

“Bear Trap: Will Tech Stocks Sink the

Rest of the Market and the Economy?”

– U.S. News & World Report,

March 26, 2001

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In 1977, at the time of Elvis Presley’s death, there were 170

Elvis impersonators worldwide.

In 2000, there were 85,000 Elvis impersonators.

At this rate of growth, statisticians predicted that by 2019,

Elvis impersonators would make up 1/3 of the world’s population.

Extrapolation

Source: http://www.murderousmaths.co.uk/elvis.htm; Freemovement.org, November 13, 2007

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Framing

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Attention Response & FramingS&P 500 Annual Returns (1928-2015)

Source: Prof. Robert Shiller data. http://www.econ.yale.edu/~shiller/data.htm. Past performance is not a guarantee of future results. One cannot invest

directly in an index.

11.4%

Average

Annual

Return

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Attention Response & Framing

Source: Prof. Robert Shiller data. http://www.econ.yale.edu/~shiller/data.htm. Past performance is not a guarantee of future results. You may not invest

directly in an index. Does not represent all market declines of 10% or more.

-25%

-44%

-35% -11%-13%

-10%

-14%-26%

-12%-22%

-37%

10

100

1000

10000

100000

1000000

% R

etu

rn

S&P 500 Index (1928-2015) Calendar Years With Declines in Excess of 10%

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Meet Dr. Eben Otuteye and Mohammad Siddiquee

“Volatility is not a surprise.

Volatility is neutral;

it is just part of what the asset is.

“Redefining Risk and Return”

Volatility ≠ Risk

But you can turn it into risk if you mishandle it.”

Source: Otuteye, Eben and Mohammad Siddiquee. “Redefining Risk and Return in Common Stock Investment from a Value Perspective.”

https://www.brandes.com//docs/default-source/brandes-institute/2015/redefining-risk-and-return

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Source: Inspired by Marks, Howard. The Most Important Thing: Uncommon Sense for the Thoughtful Investor. New York: Columbia

University Press. 2011. Hypothetical illustration does not represent any particular investment. Actual results will vary.

Risk Perceptions

More Risk Doesn’t Necessarily Mean More Return

-100

-50

0

50

100

150

200

Low Low to Medium Medium Medium to High High

Po

ten

tia

l R

etu

rn %

Risk Level

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Risk Tends to Diminish Over Time…

Source: S&P Dow Jones Indices, as of 12/31/15. U.S. stocks represented by the S&P 500 Index. Rolling periods represent a series of overlapping, smaller

time periods within a single, longer-term time period. For example, over a 20-year period, there is one 20-year rolling period, eleven 10-year rolling periods,

sixteen 5-year rolling periods, and so forth. Past performance is not a guarantee of future results. One cannot invest directly in an index.

-60%

-40%

-20%

0%

20%

40%

60%

2 Yr 5 Yr 10 Yr 20 Yr 30 Yr

Ra

ng

e o

f T

ota

l R

etu

rns (

An

n.)

%

Range of Total Returns for U.S. Stocks Over Various Rolling Periods (1926-2015)

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Risk and Return: Ask Your Clients a Simple Question

“What do you expect returns to be next year for the stock

market? Give me a range of outcomes.”

• Do they include a negative number in their range?

• If not, have a conversation about expectations and short-term returns.

Source: Jay Mooreland, www.theemotionalinvestor.org

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Source: Carl Richards at www.behaviorgap.com

Avoid This Behavioral Pattern!

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Investment Process: The Essentials

Source: CFA Institute report, “Manager Selection” by Scott D. Stewart, CFA. Dec. 2013.

IPS Features and Implications

1. Client description (asset size, cash flow profile, liabilities)

2. Duties (asset class selection, manager selection, fee negotiation,

monitoring)

3. Objectives (total vs. relative, real vs. nominal, risk objectives,

fees/expenses)

4. Constraints (liquidity, horizon, taxes, legal, restrictions)

5. Asset allocation targets (asset class selection, acceptable styles,

number of classes)

6. Rebalancing guidelines (frequency and rules)

7. Schedule for reviews (frequency and access)

Investment Policy Statement

Source: Jim Ware, CFA and Brian Singer, CFA. “Decision Making: A Process Check for Investment Firms.”

Decision Rights

How Do We Make Decisions?

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Evaluating “Success”

Source: Russo, J. Edward and Paul J. H. Schoemaker. Winning Decisions: Getting It Right The First Time. 1st ed. New York: Random House. 2002.

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Investor Stress Management Plan (ISMAP)

1. Positive activities they control

2. Investment plan

3. Sign it

Source: MarketPsych and Brandes Investment Partners

Hiring or firing managers

Adopting strategies/approaches that have

had recent success—or abandoning

strategies that have fared poorly recently

Confusing skill with luck when evaluating

managers

Looking at high returns without

considering risks

Recognizing Potential Biasesin Decision-Making

Source: Bob Maynard. “Behavioral Finance: Pitfalls and Prevention for Plan Sponsors.” Brandes Institute. 2004.

Evaluating the products without

evaluating the firm

Avoiding “high-risk” investments

because of perceived volatility

Relying on skill in selecting a

“better-than-average” manager

Decisions where leverage is involved

Source: Bob Maynard. “Behavioral Finance: Pitfalls and Prevention for Plan Sponsors.” Brandes Institute. 2004.

Recognizing Potential Biasesin Decision-Making

Explanations in simple language

Appoint a devil’s advocate

Establish and perpetuate a culture

of debate

Use quantitative evidence—wisely

Source: Bob Maynard. “Behavioral Finance: Pitfalls and Prevention for Plan Sponsors.” Brandes Institute. 2004.

Preventing Bias From Affecting Decisions

Create and follow a comprehensive

investment policy

Focus on the long term

“Pre mortem”

Document successes and failures

Source: Bob Maynard. “Behavioral Finance: Pitfalls and Prevention for Plan Sponsors.” Brandes Institute. 2004.

Preventing Bias From Affecting Decisions

Review staff capabilities

Set clear objectives and short-term risk tolerances

Provide “stabilizing, rational consistency”

Maintain stable committee with terms of 5 to 6 years, renewable once

Achieve average manager tenure of 10 years or more

In What Areas Should Investment Committees Focus?

Source: CFA Institute report, “Manager Selection” by Scott D. Stewart, CFA. Dec. 2013.

CFA Institute Recommendations

Understand how we make decisions―and which system we use

Be aware of specific biases and use tools/tactics to help counter them

Think long term

Seek additional resources if needed

In Closing…

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VALUE SPECIALISTS SINCE 1974

CALL BRANDES NOW 800.237.7119

BRANDES.COM

11988 El Camino Real │ Suite 600 │ P.O. Box 919048 │ San Diego, CA 92191-9048

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Disclosures

Robert Maynard is a member of the Brandes Institute Advisory Board.

The S&P 500 Index with gross dividends measures equity performance of 500 leading companies in industries of the U.S. economy.

The information provided in this material should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any

security transactions, holdings or sectors discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be

profitable or will equal the investment performance discussed herein. Portfolio holdings and allocations are subject to change at any time and should not be

considered a recommendation to buy or sell particular securities. Strategies discussed herein are subject to change at any time by the investment manager in its

discretion due to market conditions or opportunities. International and emerging markets investing is subject to certain risks such as currency fluctuation and social

and political changes; such risks may result in greater share price volatility. Unlike bonds issued or guaranteed by the U.S. government or its agencies, stocks and

other bonds are not backed by the full faith and credit of the United States. Stock and bond prices will experience market fluctuations. Please note that the value of

government securities and bonds in general have an inverse relationship to interest rates. Indices are unmanaged and are not available for direct investment.

The foregoing reflects the thoughts and opinions of Brandes Investment Partners® exclusively and is subject to change without notice. Brandes Investment

Partners® is a registered trademark of Brandes Investment Partners, L.P. in the United States and Canada.

Rolling periods represent a series of overlapping, smaller time periods within a single, longer-term time period. For example, over a 20-year period, there is one 20-

year rolling period, eleven 10-year rolling periods, sixteen 5-year rolling periods, and so forth.

The recommended reading has been prepared by independent sources which are not affiliated with Brandes Investment Partners. Any securities mentioned reflect

independent analysts’ opinions and are not recommendations of Brandes Investment Partners. These materials are recommended for information purposes only and

should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Past performance is not a guarantee of

future results. No investment strategy can assure a profit or protect against loss.

Brandes Investment Partners does not guarantee that the information supplied is accurate, complete or timely, or make any warranties with regard to the results

obtained from its use. Brandes Investment Partners does not guarantee the suitability or potential value of any particular investment or information source.

No investment strategy can assure a profit or protect against loss.

35

VALUE SPECIALISTS SINCE 1974

CALL BRANDES NOW 800.237.7119

BRANDES.COM

11988 El Camino Real │ Suite 600 │ P.O. Box 919048 │ San Diego, CA 92191-9048

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The Stroop Effect: Testing our Brain

Source: University of Washington. https://faculty.washington.edu/chudler/java/timesc.html

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The Stroop Effect: Testing our Brain

Source: University of Washington. https://faculty.washington.edu/chudler/java/timesc.html