Paul Craven, Head of EMEA Institutional Business

December 2010

Behavioural Finance: from market cycles to collective decisions…

Private and Confidential

This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.

“The Elevator Pitch” What affects prices and group decisions?

A. The Folly of Crowds?

B. Five behavioural biases

C. Being part of a ‘wise crowd’ – building a good team

2

The objective is to become a better decision maker, individually and collectively

A: The Folly of Crowds?

Behavioural finance seeks to explain the psychology of markets and groups of people • The relationship between prices and people • Irrational behaviour – individual greed and fear? • The herd instinct?

3

…………….. or ‘wise’? Are crowds ‘mad’

1841 2004

The Anatomy of Price Bubbles

Source: Kindleberger, C. (1978). Manias, Panics, and Crashes. Andrei Shleifer. (2000). Inefficient Markets 5

1. ‘Displacement’- Initial good news, generating substantial profits for early adopters

e.g. Dutch Tulipmania (1630s)- New Tulip types engineered and sold in prosperous Holland

2. ‘Smart Money response’- Increasing prices lead to greater supply and claims on assets e.g. Florida land Boom (1920s)- Building of new homes and transport links

3. ‘Sustaining the bubble’- Creation of new financial products to take advantage of the opportunity and sustain ‘noise traders’ enthusiasm

e.g. Argentine Loans (1880s) –New issues on the LSE of joint-stock companies to speculate on Argentinian Land

4. ‘Authoritative blessing’- At top of bubble the backing of a respected person or body helps to maintain momentum

e.g. US Stock Market boom (1920s) - Blessings from Coolidge, Hoover and Mellon

5. ‘The Crash’- Big losses occur, especially to noise traders, as market correction takes place

e.g. US Stock market Boom (1920s) - October 1929 market fell 24%

6. ‘Political Response’- aimed at speculators and those who helped engineer the bubble e.g. US Stock market Boom (1920s) – 1933Glass Steagall Act and creation of SEC

B: Five Behavioural Biases 1. ‘Information cascades’- Herd Instinct

• You observe other’s actions before you make your own decision

• An ‘information cascade’ arises if it becomes optimal to ignore your own information in favour of the (inferred) information of others

• The herd instinct…

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0

1000

2000

3000

4000

5000

01/04/1997 01/04/1998 01/04/1999 01/04/2000 01/04/2001 01/04/2002

NASDAQ

1. Information cascades Cont. e.g. The Dot-Com bubble

Chart as of 2010. Source: NASDAQ Bloomberg, Source: Kindleberger, C. (1978). Manias, Panics and Crashes, Andrei Shleifer. (2000). Inefficient Markets.

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‘Political Response’ Backlash against those who helped drive the

bubble through market malpractice.

‘The Crash’ From peak to trough the Crash wiped 83% of the

NASDAQ Index

‘Authoritative blessing’

The UK government sells 3G licences to bidders in April 2000 ‘Sustaining the

bubble’ IPOs and new ‘day traders’

became common place. Relying on growth and perceived value, not

earnings. ‘Displacement’ Mosaic Web browser

growth and rising perceived valuation of internet based firms.

‘Smart Money response’

Venture Capital flowed in to many fledgling Dot-Com

start ups.

10/03/2000

5,048

1997 1998 1999 2000 2001 2002 2003

2. Conformity The Asch experiment

• In the 1950s, Solomon Asch developed a series of experiments examining whether perception could be influenced by social pressure.

• Asch showed cards with pictures like this to groups of 8 to 10 college students:

• The subject was told he was studying visual perception – his task was to decide which of the bars on the right was the same length as the one on the left.

• (All the other students voted the same way for a wrong answer before the subject gave his answer).

Source: Solomon Asch. 8

2. Conformity continued Asch – results

• Tests showed:

75% yielded to the majority on at least one trial.

50% of the subjects yielded on more than half of the trials.

25% of the subjects never conformed.

• The subjects exhibited a great deal of stress in these experiments.

• If only one of the confederates ‘dissented’, the rate of conformity fell dramatically.

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Real life examples include canned laughter on television, fashion, teenage smoking and the ‘Abilene Paradox’

2. Conformity and cycles

A graphical illustration (Europe ex UK). Source: Goldman Sachs Global ECS Research, Worldscope, Haver Analytics, Datastream. For illustrative purposes only. 10

‘Optimism’

-24.9% p.a.

+51.2% p.a.

+10.9% p.a.

+27.1% p.a.

0 2 3 4 5 6 7 1

Average length (years)

‘Despair’ ‘Hope’ ‘Growth’

Europe ex UK Real price return (%)

3. Anchoring – US corporate credit spreads

Source: Federal Reserve, Merrill Lynch as of 31-Dec-09. This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. 13

Where will spreads go from here?

0

100

200

300

400

500

600

700

800

1925 1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009

BBBs

Spre

ad o

ver T

reas

urie

s (B

ps)

4. Authority The Milgram experiment

• One of the best known experiments in social psychology is that of Milgram (1961).

• In this set of experiments, carried out at Yale in the early 1960s, Milgram studied the influence of ‘authority’ on decision making.

• More recently Morck (2007) explores the implication of Milgram’s findings for corporate governance and board independence.

Source: Milgram. 15

4. Authority continued Milgram – room layout

Source: Milgram, 1974. 16

W

A

L

L

Authority figure

Answers questions

ACTOR

ACTOR ‘the learner’

Test subject Asks

questions

4. Authority continued Milgram – results

Source: Milgram. 19

These results stunned scientists and psychiatrists (who had expected only 1% to go to the maximum)

Over 60% of participants went to the maximum voltage

5. The power of stories

Stories: • Are universal, crossing boundaries of language, culture and age

• Mirror human thought (we think in narrative structures e.g. past, present, future)

• Define who we are (easier to identify with an individual than a ‘statistically average person’)

• Build a sense of community

• (nb: In this context, ‘stories’ do not mean lies or half-truths.)

Source: Loick Roche, John Sadowskey, ‘The Power of Stories’, International Fund of IT and Management 2003. 23

Stories generate emotion!

Action oriented biases Drive us to take action less thoughtfully than we should

E.g. excessive optimism, overconfidence, competitor neglect, information cascades

Stability biases Create a tendency toward inertia in the presence of uncertainty

E.g. anchoring, loss aversion, sunk-cost fallacy

Social biases Arise from the preference for harmony over conflict

E.g. group think, conformity, sunflower management, influence of authority

Behavioural biases A summary of typical

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Interest biases Arise in the presence of conflicting incentives

E.g. individual incentives, inappropriate attachments, misunderstood goals

Pattern recognition biases

Lead us to recognise patterns even when there may be none

E.g. confirmation bias, power of story-telling, champion bias

Source: McKinsey Quarterly, 2010.

‘mental shortcuts’

Golf: “The way to win is by making fewer bad shots…” (Tommy Armour)

Tennis: “The victor in a game of tennis gets a higher score than the opponent, but he gets the higher score because his opponent is losing even more points.” (Charles D. Ellis)

“Winning the Loser’s Game” Investment lessons from sport

• Play your own game

• Keep it simple

• Concentrate on your defences

• Don’t take it personally

Source: The Loser’s Game, Charles Ellis, financial Analysts Journal, July 1975 http://www.ifa.com/pdf/EllisCharlesThe_Loser's_Game1975.pdf 29

This can apply to waging war, campaigning for office, flying a plane…and investment

C: Being part of a wise crowd i.e. building a good team

• Francis Galton’s article ‘Vox Populi’:

West of England Fat Stock and Poultry Exhibition at Plymouth in 1907.

Galton collected the estimates submitted in a weight judging competition for an ox.

• The median estimate on the 787 tickets was 1207 lbs, the mean was 1197.

• The actual weight was 1198 lbs.

30 Source: James Surowiecki, The Wisdom of Crowds

Necessary ingredients for wise crowds

• Diversity of opinion

• Independence

• Decentralisation (specialist or local knowledge)

• Aggregation (ability to make collective decisions)

Source: James Surowiecki, The Wisdom of Crowds 31

These appear necessary ingredients for any effective team…

… including decision making groups and executive boards

• WWTBAM?

• Prediction markets, opinion polls

• ‘Crowdsourcing’ …especially online

Examples include:

- web collective intelligence e.g. Google, Wikipedia

- consumer democracy e.g. Amazon

- problem solving e.g. InnoCentive, Brainrack

Crowdsourcing, Jeff Howe , 2008

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Wise crowd examples

Avoid ‘groupthink’

Symptoms of ‘Groupthink’

1. Illusion of invulnerability creating excessive optimism.

2. Collective rationalisation that might challenge the group's assumptions.

3. Belief in the inherent morality of group

4. Stereotyped views of those who are opposed to the group as wrong or stupid.

5. Direct pressure to conform placed on any ‘disloyal’ member.

6. Self censorship of ideas that deviate from the perceived group consensus.

7. Illusions of unanimity among group members; silence is viewed as agreement.

8. Self appointed mind guards — members who shield the group from dissenters.

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“If you never change your mind, why have one?” (Edward de Bono)

Source: Irving Janis.

Making sure the right people are involved Ensure there are a diversity of backgrounds, roles, interests and personality types.

Assign homework Do due diligence based on independent facts.

Create the right atmosphere Encourage all members to speak up and have a ‘Devils Advocate’.

Wise Crowds- ways to combat ‘groupthink’

Source: McKinsey Quarterly, 2010. 20

Follow up

Commit yourself to the decision, communicate them to the group and review your decision making process regularly.

Manage the debate Set an agenda, devise a voting system and have clear goals.

Conclusions

Prices and group decisions will reflect fully aggregated, diverse information when individuals use their own inputs.

However, watch out for ‘mental shortcuts’ including:

1. information cascades

2. the influence of conformity

3. anchoring on irrelevant information

4. the influence of authority

5. the power of stories

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Recognising such biases should allow you, as an investor or a decision maker, to be more effective

Appendix

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Biography

Paul Craven Head of EMEA Institutional Business, Goldman Sachs Asset Management

Paul is head of EMEA Institutional Business. He joined Goldman Sachs Asset Management in 2007 as a managing director. Prior to joining the firm, Paul worked at PIMCO Europe Ltd for four years, where he was head of UK Business Development. Previously, he spent seventeen years at Schroders as a portfolio manager and latterly as head of UK Institutional Sales. Paul has an MA (Hons) in History from St. John’s College, Cambridge University and is a member of the CFA Institute, the UK Society of Investment Professionals and the Magic Circle

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