FEATURE: MEAN VARIANCE
admitting that they were wrong may make it diffi cult to accept. It may
even lead to the development of complicated theories to explain away
PROFILE – FACT BOX
contradictory evidence. Th is is known as cognitive dissonance. Claims
that this time it’s diff erent or that there are special reasons why lessons
from history don’t apply to current circumstances fall into this category
of bias. Such behaviour may be reinforced by contagion. If my
colleagues and competitors hold a particular view, then I feel more
comfortable also holding that view even if logic should dictate
otherwise. I am happy to own expensive structured credit instruments
because I have justifi ed to myself why they represent good value (even
though history suggests a greater risk than is priced in) and other
investors are doing exactly the same thing, so it must be OK.
Behavioural traits not only contributed to the overpricing of assets
on the way up but also exacerbated the turmoil. In particular, extreme
loss aversion resulted in a drying up of liquidity in many markets. Th is
then encouraged some of the behavioural biases mentioned above to
work in reverse. Investors overestimated the probability of default
associated with many securities; the experience of painful losses led to
the withdrawal of many market participants who did not understand
what was going on; banks refused to trade with each other because
other banks were not trading with each other. To some extent these
Daniel Murray, CFA
behavioural biases can be self-reinforcing. If investors expect weak Career highlights:
markets – based in part on behavioural biases – and withdraw Daniel Murray, CFA, is director of strategy
signifi cant funds accordingly, this will contribute to the fulfi lment of for Russell Investments and works with
those expectations. many departments including the hedge fund,
private equity and capital markets teams.
PUTTING IT ALL TOGETHER
Previous roles as an economist, asset
Accepted wisdom is that a diversifi ed basket of higher-risk assets will
allocator and portfolio manager have served
generate higher returns over a suffi ciently long time period. Th is has
as invaluable experience providing exposure
been challenged by the experience of the past two decades, not least the
to a broad range of markets, instruments
past two years. Moreover, it has been shown that simple techniques
and investment styles. Before joining
would have been helpful in terms of identifying higher-risk periods,
Russell, he was employed as a director of
both over the longer term and also more recently. At a basic level, this
EFG Asset Management, having previously
latter observation is in confl ict with the effi cient markets hypothesis.
worked at Merrill Lynch Investment
Behavioural fi nance theory is helpful in terms of explaining why
Managers. Murray has a PhD in economics.
otherwise intelligent, rational investors act in ways that are seemingly
inconsistent with their available information sets. While these
behavioural theories are useful as the basis for explanation, it is much look cheap, yield curves are steep and
harder to take them into account when forecasting, not least because implied defaults are high. Taken together this
of the diffi culties involved in identifying which biases are likely to suggests a greater degree of comfort in
dominate and in which direction they will work. accepting increased portfolio risk. A practical
A reader may deduce from this article that one need only keep an diffi culty is that, as mentioned above, cheap
eye on cyclically adjusted valuations, the slope of the yield curve and assets can get cheaper. Having the nerve to
implied defaults to be a successful investor. Yet this view is too stick to a rational, objectively derived strategy
simplistic. Th e scope of this article is insuffi cient to go into detail on is diffi cult when faced with short-term
any one issue so instead selective evidence has been presented to market movements that are in confl ict with
illustrate a general point. In practice, the information set that investors your view. Even if investors are aware of the
have to digest is large and varied. It is a rare talent to be able to pitfalls associated with the various
identify which parts of that information set are most pertinent for behavioural biases it remains hard to alter
markets at any point in time. Th e implication is that successful active one’s own behaviour, regardless of the weight
management requires huge amounts of skill and deep market of evidence that may support an investment
knowledge, regardless of one’s view on effi ciency. view. Th ere is always the nagging doubt that
Nonetheless, it is true that cyclically adjusted valuations currently maybe, just maybe, this time it’s diff erent.
WWW.CFAUK.ORG PROFESSIONAL INVESTOR 27
23-2723-27 mean variance.indd 27mean variance.indd 27 1/6/091/6/09 11:50:4411:50:44Professional Investor Summer 09.29 29 4/6/09 15:40:55
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