Adjusting to new conditions

Institutional investors and fund managers have responded to the increasing anonymity and media-hype surrounding the global finance industry typified by financial channel programs.

At financial industry conferences, organizers frequently implore delegates to understand behavioral norms and attitudes in order to make greater profits, whilst the founders of the school of behavioral finance set up a fund management company to put their theories into practice (www.fullerthaler.com). Training in the role of behavior starts with attitudinal analysis of simple puzzles (for example, of a limited set of identified competing nations, which one will win the World Cup? Of those identified as likely finalists which will win? And by what margin?). Once inducted into the process, more complicated tests are introduced. For example, participants may be asked to anticipate the average score (between 1 and 100) of the group.

underlining the recursive nature of successful decision-making, and the difficulties encountered because the audience is uncertain as to the composition and attitudes existing in the audience.⁸

There are three key issues arising from this example. First, even amongst industry experts the context, knowledge of other participants, and the specific questions are all important variables in decision-making. Although familiarity with the process means that participants converge around expected norms and standards, this kind of accumulated knowledge is unusual in the financial industry. Not only do market participants change over time, the issues faced and the setting in which they are played-out also vary in unpredictable ways. There are many risks in simply repli­cating the past as if the future is yet another version of the past. Producing an investment product, for example, is quite unlike producing a manufactured product (Clark, 2000). Performance is assessed according to a benchmark whose value is only known at the end of future periods of time. Consequently, market agents are vulnerable to unanticipated events and actions within a mandate period. Further­more, as financial markets are comprised of many different kinds of people, the heterogeneity of market expectations and emotions is a necessary ingredient in sustaining market liquidity; those markets dominated by one kind of participant with common expectations are ultimately self-defeating (Clark, 2002).

The issue of market expectations is not simply resolved using the dichotomy between expert and non-expert. For example, at a recent finance industry con­ference, expert participants were shown two videos. The first advertised investment management by using the tools of the MTV generation, stressing the “hipness” of a product in relation to current trends, while the second was more sober and stressed the relative performance of the product against an appropriate benchmark.

The growing heterogeneity of expectations and significance of the media has changed the way finance works. For some, especially consultants concerned with advising institutional investors about the investment decision-making process, these kinds of puzzles and video shows have encouraged close attention to the norms and principles under-pinning the process of decision-making. Whereas recognition of psychological biases and related cognitive traps have served as one element in this re-invigorated emphasis on process, check-lists and codes of practice have served as means of encouraging best-practice. Other avenues of process-based advice have included a focus upon decision-making in groups and the limits of

Performingfmance 177 information-rich decision-making. In essence, commonplace assumptions about the necessary rationality of market agents have had to be rejected in favor of formulating models of decision-making that are sensitive to context, cognition and opinion. Such models may not find favor with many finance theorists. But they are increasingly the focus of industry participants and government regulators. For many years, it was self-evident that financial decision-making would be best when informed by the principles of modern portfolio theory.

There remains an unresolved debate as to the significance of market volatility for short-term and long-term investment policy. There is no doubt that being able to take advantage of increased market volatility may generate high rates of return for larger institutional investors who have the resources to mine the data, respond immediately to trigger points, and in general take advantage of the “remoteness” of individual investors from the flow of gossip within and between such firms. In this respect, knowledge of the scope of existing market expectations combined with empirically-tested models of common psychological traits in specific market conditions may provide such institutions with significant tactical advantage in designing market trading regimes. However, it remains to be seen whether tactical advantage can be translated into strategic advantage with respect to long-term asset allocation. Here, there are some who believe that attention to the fundamentals driving long-term rates of return between different classes of financial assets remains an essential component of any winning investment strategy (Campbell and Viceira, 2002). By this logic, the rise of the media image is a real threat to the welfare of most market participants since it continually imposes alien logics of calculation.