Views & Innovations

Expanding the risk
management toolbox

Apr 11, 2017

BlackRock has always been a leader in embracing innovation—from as many dimensions as possible—for the benefit of our clients. Our Risk & Quantitative Analysis group has recently launched a Behavioral Finance group tasked with supporting our investment teams’ search for alpha. This team works closely with portfolio managers to increase their understanding of systematic behavioral tendencies and further improve investment decision making.

Executive summary

Portfolio management teams have historically followed systematic investment and risk processes steeped in financial analytics and evaluation. But what if there was more to the process—beyond numbers and models—hidden from view and linked to how the brain processes information? More precisely, there may be identifiable risks in our thinking and decision-making based on behavioral biases or tendencies. These types of biases impact our decisions every day. For example, we tend to place more weight on the most recent news rather than older information, just because it’s newer! Embedding behavioral science insights into the risk management dialogue is one of the many ways BlackRock seeks to continuously innovate on behalf of our clients.

Beyond the numbers

As a leader in the field of risk management, BlackRock is consistently exploring new ways to understand, assess and analyse risk for the purpose of seeking investment outperformance for our clients. This is especially important in light of the long-term investment and retirement horizons faced by many of our clients and their constituents. Many portfolio managers design their investment processes to capture the relative financial performance of individual securities or industry sectors. Conversations with their respective risk managers, based on output from analytical models, help portfolio managers make decisions on where and how much capital to allocate across their investable universe.

But what if there was more to the process—beyond numbers and models—hidden from view and linked to how the brain processes information? For example, what if an investor was choosing technology company X over company Y—simply because he had read about X more recently? Or what if an investor placed more value on a stock in their portfolio rather than one of similar value outside their portfolio just because they had already bought it?

More precisely, what if identifiable risks in our thinking and decision-making could be impeding our ability to best meet our client’s goals? This is where the field of behavioral science—and more specifically, behavioral finance—enters the equation. Behavioral science as a field of study goes back to at least the 1960s with the ground-breaking work of Daniel Kahneman and Amos Tversky. Most risk managers are trained in traditional quantitative metrics for measuring risk. Yet they are also becoming more familiar with the psychology of risk-taking and the behavioral biases which might impact portfolio managers’ decision making.

As Kahneman and Tversky evolved from quirky academics studying this niche intersection of judgement and decision making to well-known behavioral economists, their work and its practical implications for business has begun to be recognized worldwide. BlackRock has invested in a dedicated behavioral finance team within our risk management business. The U.S. and UK governments have set up dedicated behavioral insight groups. And many firms have begun to actively recruit behavioral scientists.

Systematically irrational

The core theory behind behavioral science is that humans regularly make decisions in manners which classical economic models would consider irrational. These systematic behavioral biases are a function of mental blind spots, or assumptions not explicitly recognized by the mind. These weaknesses can result in the mind taking shortcuts—called heuristics—without realizing it. For example, we all have pre-conceived visions for what an athlete should look like. When given the picture and profile of several athletes, say basketball players, and asked who we think is the best player, we tend to gravitate toward the one who most represents our pre-conceived expectations (See Michael Lewis’s 2016 book, The Undoing Project: A Friendship that Changed Our Minds). This immediate judgement may cloud our ability to objectively evaluate all candidates solely based on their actual level of performance. 

In order to optimise decision-making processes, it is important to become more mindful of the way we make decisions. In an investment context, it’s important that the decision-making process followed by teams is enhancing performance relative to the broader market, not detracting from it. Thus, the behavioral finance team at BlackRock is focused on helping risk managers and portfolio managers become more mindful of common cognitive blind spots and building tools to identify and limit what could be subtle but important irrational behaviors.

The SPORT framework

The list of tested behavioral biases can grow unmanageably long (and confusing), but we think a simple framework can help risk and portfolio managers recognize and understand the “roots of bias”. In reality, bias can stem from an individual’s past experiences as well as current situational factors. These “roots of bias” eventually lead to various irrational tendencies in our decision-making. Thus, correcting any sort of decision-making detour must begin with recognizing those influences.

Sticking with athlete analogies, many portfolio managers think of themselves as professional athletes—monitoring themselves to ensure they are in optimal decision-making shape, diligently measuring their improvement through time, and competing to make the best investment decisions on behalf of their clients. So it’s only natural that the acronym for these roots of bias is SPORT. The five roots of bias we focus on are: Self, Physical environment, Others, Randomness, and Time. Below are some examples of the biases we think stem from each of these roots of bias.

Roots of Bias Guide1

Root of BiasExampleApplicationWays to Mitigate Bias
Self
Humans have a natural inability to accurately assess their own skill, the accuracy of their views and their level of control.
Over-confidence An investor who believes he has more skill in a specific market may unintentionally take outsized risks. Systematically conducting post-mortems to critically look at trade sizing and outcomes across markets in the portfolio.
Physical Environment
The environments in which decisions are made can influence the outcomes of those decisions.
Familiarity bias Familiar countries and industries can appear more attractive (less risky or having higher return potential) to an investor, even when evidence is to the contrary. Incorporating a “home bias” test into the stock assessment process in order to limit the tendency to overweight positions in familiar markets.
Others
Decisions are often influenced by other individuals – particularly when the “others” share a similar perspective.
Groupthink  An investment team may focus most of their discussion around shared information, rather than bringing unique information to the table. Documenting individual views ahead of a meeting will lower the chances of anchoring the conversation on a key speaker’s views.
Randomness
Humans face challenges dealing with the inherent uncertainty of a changing world–sometimes coupled with or caused by a lack of risk literacy.
Loss aversion Higher propensity to avoid losses and the associated pain than to seek the equivalent upside potential and positive emotion can lead to loss of investor confidence and hesitation to take attractive risks. Working closely with risk managers to monitor risk taking and ensure that lower than normal risk levels are addressed as proactively as higher than normal risk levels.
Time
Time complicates decision making because humans find it difficult to be patient when time moves slowly – as well as acting dynamically when time moves quickly.
Endowment effect An investor might begin to overvalue his existing bets because they have been in the portfolio for a long time. Charting intended time horizons of each investment and then regularly revisiting the thesis to reaffirm conviction level.

 

Increasing awareness of the above, as well as other types of human biases, has broadened our understanding of potential risks which may influence the decision-making behavior and judgement of portfolio managers. Embedding behavioral science insights into the risk management dialogue is one of the many ways BlackRock seeks to continuously innovate on behalf of our clients, recognizing that even the slightest improvement can magnify the benefits for our clients—be it for the purposes of retirement or other objectives—across a broad spectrum of time horizons.

Bruce Wolfe, CFA
Executive Director, BlackRock Retirement Institute
Bruce Wolfe, CFA, Managing Director, is a member of the US & Canada Defined Contribution (USDC) Group. Bruce is the Executive Director of the BlackRock ...