Making Group Decisions: Insights and Innovations in Behavioral Finance for Fiduciaries

Transcription

1 GLOBAL INSTITUTIONAL CONSULTING Making Group Decisions: Insights and Innovations in Behavioral Finance for Fiduciaries Michael Liersch, Managing Director, Head of Behavioral Finance Anil Suri, CIO, Multi-Asset Class Modeled Solutions Investment success can rest on tailoring an approach to meet an institution s unique financial goals. But what should be done when an investment committee s or board s opinions and goals diverge? Fortunately for institutions large and small, behavioral finance offers numerous insights and suggests several approaches for reconciling the dissimilar financial perspectives that sometimes arise within groups. When investment boards or committees make decisions, a common question arises: How can we reconcile multiple people s perspectives and goals to make wise investment decisions for the group, while avoiding unwise ones? Insight into the answer can be found by asking a related question that has plagued academic researchers for many decades: Who makes better decisions an individual or a group? 1 As with many questions, the answer depends on a variety of factors. For example, researchers Christoph Gort and Anke Gerber found that when making asset allocation choices, individuals and groups risk-return trade-off choices were, on average, surprisingly similar. 2 However, upon further examination, the researchers discovered that certain groups made better risk-return trade-offs relative to individuals, while other groups made worse trade-offs. The element that seemed to drive group out- or under-performance was the level of communication, or information exchange (see Figure 1). Among other factors, higher-performing groups spent more time discussing the problem to be solved and generated more problem-solving suggestions. Figure 1: Factors that can affect risk-return trade-offs groups make High Information Exchange Groups Low Information Exchange Groups Average time focused on asset allocation decision Sources: Adapted from Gort and Gerber, 2008 Average number of group member suggestions 23 minutes minutes Sharpe Ratio, where higher values equate to better risk-return trade-offs 1 For a review of research examining group decisions and performance, see J. Richard Hackman and Nancy Katz, Group behavior and performance, in Handbook of Social Psychology, Christoph Gort and Anke Gerber, The performance of groups and individuals in financial decision-making, National Centre of Competence in Research, Financial Valuation and Risk Management, Working Paper No. 460, Performance was determined by the Sharpe Ratio, which measures the benefit of excess return above the risk free rate relative to risk, or standard deviation. Key Implications Groups of affiliated investors especially those acting in a fiduciary capacity often recognize that good communication can lead to better investment decisions. However, facilitating constructive dialogue can be challenging. Start by (re)establishing the group s investment purpose. When guided by common goals (e.g., an Investment Policy Statement), times of significant change in the markets can present an ideal opportunity to air out feelings about risk and return and reassess the desired trade-off between them. Pinpoint areas of agreement and disagreement. Facilitating an environment where every group member s viewpoints are taken into account can lead to a structured discussion in which differences are narrowed and all parties are listened to. The dialogue alone can go a long way toward achieving unity of purpose and, ultimately, successful investment outcomes. Merrill Lynch s Fiduciary Investment Personality Assessment can help. The proprietary assessment can highlight the group s Mindset toward risk, preferred Approach to achieve the institution s goals, and its perspectives on the institution s Purpose for the investment dollars. By discussing the results as a group, action steps can be identified to enable the investment process to constructively move forward. Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S) and other subsidiaries of Bank of America Corporation. Investment products: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value MLPF&S is a registered broker-dealer, Member SIPC and a wholly owned subsidiary of Bank of America Corporation.

2 Obstacles to Group Communication Many groups of people believe that simply coming together and verbally sharing ideas will automatically lead to good decisions. While this can be true, without a structured process for communication, there can be severe obstacles to information exchange. For example, in group settings it is not uncommon for an individual who is often the most experienced investor or primary decision maker to lead the discussion by first expressing his or her own opinion. This can cause others to go along with that view even when they may not actually share it. To highlight this point, let s walk through a classic psychological example demonstrating people s propensity toward group conformity. Imagine that you were asked to participate in a vision test. For this test, please closely examine Figure 2 below. Which line matches the Target line A, B or C? Most individuals agree that C matches the Target. So, would it surprise you that in a group setting many Figure 2: Asch Experiment on group conformity: Which line matches the target line A, B or C? might say that A matched the Target ) in order to examine what the unknowing participant would do. Shockingly, about 75% of individuals conformed to the pranksters (and provided incorrect responses to the vision tests) at least once. 3 There are many reasons why people might conform to a group. An individual may begin to question his or her own assessment of the correct answer, and this uncertainty leads to embracing the group s decision. Or an individual may not want to be a contrarian and experience the discomfort of going against the majority s perspective. Whatever the cause, a breakdown of communication can inhibit good group decision making and may exacerbate other group decision-making issues such as groupthink (where individuals generate reasons to support the group s decision, rather than actively considering alternatives) 4 or relationship conflict (where individuals can focus on personal differences rather than solving the task at hand). 5 Facilitating Constructive Dialogue In different variations of Solomon Asch s experiment, certain procedures significantly diminished the influence of the group. For example, if the unknowing participants wrote down their answers rather than sharing them with the group verbally, they were much less likely to conform (i.e., they were more likely to provide correct responses). Additionally, if there was one other individual that did not conform to the group, this also increased correct responses. Target A B C So how do members of a group communicate in a manner that, ideally, alleviates social pressures and enables people to share contrarian viewpoints? There are three key elements to creating an environment conducive to group decision-making: individuals are willing to say that A or possibly even B is the correct answer? Solomon Asch demonstrated individuals willingness to agree to incorrect answers in a group setting by designing an experimental prank, which involved a series of vision tests similar to that in Figure 2. In the most famous version of the experiment, an unknowing individual was placed in small groups with others who were in on the prank. The other pranksters purposefully provided wrong answers (e.g., they 1. Define the group s purpose: A shared vision of what the group is trying to accomplish can be critical to making good decisions. 6 For an investment committee or board it might be following guidelines outlined in an Investment Policy Statement (IPS) for the benefit of others. 3 See Solomon Asch, Effects of group pressure upon the modification and distortion of judgment, in Groups, leadership and men, 1951; Solomon Asch, Opinions and social pressure, Scientific American,1955; Solomon Asch, Studies of independence and conformity: A minority of one against a unanimous majority, Psychological Monographs, There are many videos available online that explain Asch s experiment (and demonstrate the procedure). 4 James Esser, Alive and well after 25 years: A re view of groupthink research, Organizational Behavior and Human Decision Processes, For a perspective on the benefits of keeping task and relationship (e.g., personal) conflict distinct, see Frank De Wit, Karen Jehn and Daan Scheepers, Task conflict, information processing, and decision-making: The deteriorating effect of relationship conflict, IACM 24th Annual Conference Paper, Wendy Van Ginkel and Daan Van Knippenberg, Group information elaboration and group decision making: The role of shared task representations, Organizational Behavior and Human Decision Processes, Making Group Decisions: Insights and Innovations in Behavioral Finance for Fiduciaries 2

3 Figure 3: How to enhance effective group communication 1. Define the group s purpose 2. Establish an information sharing methodology 3. Facilitate a discussion with a beginning, middle and end 2. Establish an information-sharing methodology: A structured process to collect the viewpoints of all individuals in the group and then aggregating those views for group discussion can facilitate constructive, actionable dialogue. For the group discussion itself, setting communication guidelines in advance increases the likelihood that each individual s thoughts, no matter how contrarian, are heard and that the informationsharing process is fair. Indeed, feelings of fairness can go a long way toward creating a positive group dynamic Facilitate a discussion with a beginning, middle and end: During the group discussion, it can be critical first to reiterate the group s investment purpose and then to keep the conversation focused on the decisions that need to be made rather than on any one individual s viewpoint. In this way, ideas, opinions or thoughts can be evaluated in the context of the problem to be solved, thus sidestepping any potential personal conflicts or the pressure to conform. Finally, setting a predetermined end time can help increase the group s focus on achieving the meeting s objectives. Taking Action To facilitate group decision-making, Merrill Lynch has established a structured method to help investment committees and boards share investment perspectives through the Fiduciary Investment Personality Assessment. 8 The assessment includes 21 questions that can be answered in 5 to 7 minutes by each individual in a group. Using Merrill Lynch s proprietary algorithm, the responses to the 21 Figure 4: 9 elements of Investment Personality Investment Investment Investment Mindset Investment Investment Investment Investment Investment Approach Investment Purpose Investment Mindset Investment Approach Investment Purpose Investment Mindset Investment Approach Investment Purpose Investment CONFIDENCE Mindset Investment ACCESSIBILITY Approach Investment Purpose SELFInvestment CONFIDENCE Mindset Investment ACCESSIBILITY Approach Investment Purpose SELF POLICY The level of access to CONFIDENCE Mindset ACCESSIBILITY Approach My focus on the My confidence Purpose about SELF CONFIDENCE Mindset ACCESSIBILITY Approach Purpose the SELF investment dollars investment policy CONFIDENCE ACCESSIBILITY the future of markets. SELF CONFIDENCE ACCESSIBILITY that SELFwould increase my statement. confidence in the strategy. ADAPTABILITY ADAPTABILITY ADAPTABILITY EXPERIENCE EXPERIENCE EXPERIENCE PROTECTION FAMILYADAPTABILITY My belief in the ability to PROTECTION FAMILYADAPTABILITY adapt portfolio, distribution or PROTECTION replenishment FAMILYADAPTABILITY strategies to changing market environments COMMUNITY and EXPERIENCE investment outcomes. COMMUNITY EXPERIENCE COMMUNITY EXPERIENCE My familiarity with markets and investing. PROTECTION PROTECTION PROTECTION FAMILY FAMILY My FAMILY desire to protect against downturns in investment value. COMMUNITY COMMUNITY COMMUNITY My interest in active involvement in the investment process. 7 In fact, when procedures are not perceived as fair, people can be more likely to attribute negative outcomes to the authority figure; Joel Brockner, Ariel Fishman, Jochen Reb, Barry Goldman, Scott Spiegel and Charlee Garden, Procedural fairness, outcome favorability, and judgments of authority s responsibility, Journal of Applied Social Psychology, Adapted from Michael Liersch and Anil Suri, Innovations in Behavioral Finance: How to assess your Investment Personality, Merrill Lynch Wealth Management Institute, Spring Making Group Decisions: Insights and Innovations in Behavioral Finance for Fiduciaries 3

4 questions by each individual can be aggregated and then translated by a Global Institutional Consultant into 7 elements of Fiduciary Investment Personality for use in a group setting (see Figure 4, on the previous page). These 7 elements can provide critical points of discussion to understand the group s Mindset toward risk, preferred Approach to achieve the institution s goals, and perspectives on the institution s Purpose for the investment dollars. Once the group s Fiduciary Investment Personality is established, the Consultant can help highlight key similarities and differences in the group s perspectives. Take, for example, the Moderate overall level of Confidence (about the future of markets) for a group in Figure 5 below. Figure 5: Example of a group's Investment Personalities concerned that the historical benefits of risk may not continue into the future. However, a large minority (40%) appear less concerned (see the first question in Figure 5). Examining how this seemingly divergent set of perspectives may be driving risk-taking decisions can be useful. In particular, group members can ensure that they are collectively anchored in the required and desired outcomes of the institution and equally informed about the (short- and long-run) risk-return characteristics of the investment strategy. Any subsequent actions (e.g., changes in the investment strategy) can then be evaluated, decided upon and implemented in accordance with the established governance structure. Concluding Thoughts and Actions Ascertaining an institution s mission and goals and helping an investment committee or board members navigate the complexities of reaching them can prove a challenge in the best of circumstances. But the challenge potentially becomes even more formidable when group members Investment Mindset, Investment Approach and Investment Purpose differ from each other. When perspectives diverge, fiduciaries and their Global Institutional Consultant can look to behavioral finance to negotiate a path forward and productively leverage differences in group perspectives to make great decisions. Taking similarities into account first can be a useful approach to generating a constructive group dialogue. In this case, all group members agree or strongly agree that financial news and market movements make them anxious (see the second question in Figure 5). Understanding what is driving the concern for example, group members fears of market volatility can motivate a focused discussion about whether the ups and downs of the institution s portfolio value are in line with the risk-return trade-offs established by the group (and the Investment Policy Statement). Additionally, all group members appear to agree or strongly agree that investmentrelated decisions are something that everyone should take part in (see the third question in Figure 5). This may help re-establish the desire for engagement and input from each group member. Once similarities are discussed, differences in perspectives can often be more productively addressed. In this case, it appears that more than half (60%) of group members are Making Group Decisions: Insights and Innovations in Behavioral Finance for Fiduciaries 4

5 Michael Liersch, head of Behavioral Finance and Goals- Based Development, is a member of the Client Segments and Advisor Development team at Merrill Lynch Wealth Management. He leads the behavioral finance and goalbased development initiatives, which are focused on tailoring investment advice to address clients unique needs, concerns and goals. Prior to joining Merrill Lynch, Michael led the behavioral finance initiative at Barclays Wealth for North and South America. He has also previously held the positions of Director of Research at Behavioral Research Associates, Consultant at Deloitte Consulting and Visiting Professor at New York University s Stern School of Business. Michael s research has been published in top psychology journals including Psychological Science and Journal of Marketing Research. His perspectives have been highlighted in investment media outlets including Bloomberg TV, CNBC, The Wall Street Journal, USA Today, On Wall Street and FundFire. Michael earned a Ph.D. from the University of California, San Diego in Cognitive Psychology. He also holds an A.B. in Economics from Harvard University. Anil Suri, Managing Director, is the CIO of Multi-Asset Class Modeled Solutions and the Head of Investment Analytics at Merrill Lynch Global Wealth Management. He leads the development of solutions for goals-based wealth management, retirement investing, behavioral finance, asset allocation, systematic portfolio management, and performance measurement across traditional, market-linked and alternative investments. Anil has been with Merrill Lynch since 2004, where he was previously Head of Investment Strategy & Analytics in the Alternative Investments area and a Senior Investment Strategist on the Merrill Lynch Research Investment Committee (RIC). Anil s research has been published in the Journal of Wealth Management and discussed in Barron s and The Wall Street Journal. His prior experience includes roles as a senior AI strategist at Citigroup, trader at Credit Suisse and management consultant at McKinsey. Anil earned an M.B.A. with honors from the Wharton School of the University of Pennsylvania, an M.S.E. (operations research and financial engineering) from Princeton University and a B. Tech. from the Indian Institute of Technology at Delhi. Making Group Decisions: Insights and Innovations in Behavioral Finance for Fiduciaries 5

6 Recent Publications from the Wealth Management Institute Summer 2012 Summer 2012 Spring 2012 Spring 2012 Spring 2012 Winter 2011 Fall 2011 Summer 2011 Summer 2011 Pitfalls in Retirement Client On-Demand Investment Performance:Behavioral Finance Considerations Innovations in Behavioral Finance: How to Assess Your Investment Personality What Behavioral Finance Has to Say About Generations X, Y, and Z Dynamic Asset Allocation Systematic Withdrawal Strategies for Retirees What is Behavioral Investing? How Behavioral Finance Can Help in Times of Volatility Portfolio Selection in Goals-Based Wealth Management Merrill Lynch s Wealth Management Institute offers clients some of the world s best intellectual capital on topics that complement our traditional investment management and portfolio construction advice. The Wealth Management Institute helps clients and advisors create holistic and customized solutions by combining Merrill Lynch s expertise in managing wealth for individuals, families and institutions with our internal thought leadership and professional network of industry luminaries and leading academics. All Wealth Management Institute thought leadership is driven and vetted by the Investment Management & Guidance leadership team. This article is provided for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Bank of America or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account a client s particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument or strategy. Before acting on any recommendation, clients should consider whether it is suitable for their particular circumstances and, if necessary, seek professional advice. GWM Investment Management & Guidance (IMG) provides industry-leading investment solutions, portfolio construction advice and wealth management guidance. Diversification and dollar cost averaging do not guarantee a profit or protect against a loss in declining markets. Since such an investment plan involves continual investment in securities regardless of fluctuating price levels, you must consider your willingness to continue purchasing during periods of high or low price levels. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available through the Merrill Lynch family of companies. Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither Merrill Lynch nor its Private Wealth Advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal, professional advisors. The Private Banking and Investment Group is a division of MLPF&S that offers a broad array of personalized wealth management products and services. Both brokerage and investment advisory services (including financial planning) are offered by the Group s Private Wealth Advisors through MLPF&S, a registered broker-dealer, Member SIPC and a registered investment adviser. The nature and degree of advice and assistance provided, the fees charged, and client rights and Merrill Lynch s obligations will differ among these services. Investments involve risk, including the possible loss of principal investment. The banking, credit and trust services sold by the Group s Private Wealth Advisors are offered by licensed banks and trust companies, including Bank of America, N.A., Member FDIC, and other affiliated banks Bank of America Corporation ARS7J6XV PM-0115