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ADVICE CORNER


How are family offices currently projecting their performance? Interviews with family offices in last year’s Global Family Office Report 2016 suggested that the process of forecasting is fairly rudimentary in many cases—in one case, involving a couple of datasets and a trend line. A legitimate challenge for family


offices is whether they need to be accurate with their one-year forecasts given their multi-year investment horizon. Indeed, the chief executive of an Asia-Pacific single family office noted: “We don’t spend a lot of time forecasting from a quantitative point of view. We do spend a lot of time thinking about the future outlook from a qualitative point of view, and the trends and directions. To us that is far more important.” One board-level adviser to family offices


says within sophisticated family offices “there is a lot more forecasting around how much risk they can afford on the downside. The focus has shifted from returns to risk budgeting.” Meanwhile some families have little


interest in forecasting at all. The managing director for one prominent New York family says it does no forecasting: “Never have and probably never will”. This leaves much room to question


if there are better ways of predicting performance, if understanding behavioural biases can help, or whether family offices should give it up altogether. Richard C Marston, James RF Guy


Professor of Finance at Wharton School at the University of Pennsylvania, admits he is not sure family offices differ that much from other institutional investors. “Pension plans and endowments also


have trouble coming to grips with what Bill Gross calls the ‘New Normal’ of lower stock and bond returns,” Marston says. Yale University’s endowment is still


predicting real bond returns of 2% and real stock returns of 6% over the next 20 years. “Yale is one of the most successful


institutional investors over the past 30 years, yet it still believes that it can achieve the types of returns that we have earned over the last 60 years,” he says.


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Marston wonders that if US growth has


truly slowed down, as well as growth in the other industrial countries, and if the US, European, and Japanese populations are aging, how can family offices earn the same robust returns we have earned in the postwar period? “Don’t expect family offices to adjust to


the new reality any faster than institutional investors,” he says.


Could behavioural finance then hold some of the answers on how to tame this unpredictability? One expert suggests that before asking how families can improve their forecasting, they need to start by asking how the wealth was originally made. “You have got to start with the psychology


of the founder or patriarch that created the family office. And then say ‘Okay, given that base [historic] psychology, how does it affect the office’s assumptions about the future risk-return environment and the family’s lifestyle expectations?’” says Ian D’Souza, a teaching professor of behavioural finance at New York University’s Stern Business School of Finance. How a family office generated its wealth


impacts a cocktail of biases they bring to financial decision-making from optimism bias to the inter-group effect (see boxout). D’Souza says his first question is how did


the family office get its wealth? “Did it come from a one-off operating


business sale, serial entrepreneurship versus managing a fund, versus real estate, versus biotechnology? Each of those have different core competences and skills when it comes to future investments and portfolio allocation. “I do not go looking for biases, I go


looking for sources of wealth generation that then led to the creation of this family office which then set the “implicit and explicit” future expectations.” An Australian, D’Souza spent six years


working up from a specialist sector analyst to a chief investment officer for a North American family office with more than $1 billion in capital, before joining NYU Stern. There he was a founding member of the NYU Stern Family Office Council which has


Optimism bias People’s tendency to overestimate the probability of positive events and underestimate the probability of negative events.


Inter-group effect The likelihood to assess people within your own circle of competence [whether due to geography, sector expertise or other clustering] more favourably than those outside of it. This is a version of group think with home bias like listening only to your neighbours because you see them every day and ignoring other people.


Anchoring bias Anchoring is the use of irrelevant information as a reference for evaluating or estimating some unknown value or information. In the context of investing, market participants with an anchoring bias tend to hold investments that have lost value because they have anchored their value to the original price rather than to fundamentals.


Sources: behavioraleconomics. com, Investopedia.com


ISSUE 72 SUPPLEMENT | 2017


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