A large body of research on the behavior of individual investors has demonstrated that low levels of financial knowledge, in addition to biases in the selection and processing of information, drive suboptimal financial choices.
Among the findings from the literature are:
Monica Gentile, Nadia Linciano and Paola Soccorso contribute to the literature on investor education and behavior with their March 2016 working paper, “Financial Advice Seeking, Financial Knowledge and Overconfidence: Evidence from the Italian Market.”
The authors write: “The effectiveness of both investor education and financial advice may be challenged by individuals’ behaviours and reactions. Unbiased financial advice can substitute for financial competence only if unsophisticated investors seek the support of professional advisors. Furthermore, advice may not reach overconfident investors deciding on their own on the basis of self-assessed rather than actual capability. Conventional financial education initiatives may exacerbate overconfidence and/or other biases distorting further investors’ decision-making process.”
Drawing on data from more than 1,000 Italian households, the authors analyzed the relationship between investors’ propensity to seek professional investment advice, financial knowledge and self-confidence, as well as the determinants of financial knowledge and self-confidence.
Following is a summary of their findings:
Gentile, Linciano and Soccorso concluded that their results confirm “concerns about regulation of financial advice being not enough to protect investors who need it most.”
They continue: “Additionally, our findings suggest that investor education programmes may be beneficial not only directly, i.e. by raising financial capabilities, but also indirectly, i.e. by enhancing people’s awareness of their financial capability and by hindering overconfident behaviours and behavioural biases. This latter outcome mitigates the worries about financial education fueling confidence without improving competence, thus leading to worse decisions.”
Summary
One of the great tragedies is that most Americans, having taken a biology course in high school, know more about amoebas than they do about investing. Despite its obvious importance to every individual, our education system almost totally ignores the field of finance and investments. This remains true unless you attend an undergraduate business school or pursue an MBA in finance. Without a basic understanding of finance and markets, there’s simply no way for investors to make prudent decisions.
Making matters worse is that far too many investors think they know how markets work, when the reality is quite different. As humorist Josh Billings noted: “It ain’t what a man don’t know as makes him a fool, but what he does know as ain’t so.”
The result is that individuals make investments without the basic knowledge required to understand the implications of their decisions. It’s as if they took a trip to a place they have never been with neither a road map nor directions. Lacking formal education in finance, most investors make decisions based on accepted conventional wisdom—ideas that have become so ingrained that few individuals question them.
And some spend far more time watching reality TV shows than they do investing in their own financial literacy. Given the important role that financial literacy plays in achieving financial goals, this is dangerous behavior.
This commentary originally appeared September 26 on ETF.com
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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE
You’re no fool. But let’s imagine for a second that a major public figure said something—something false—over and over (and over) again. Regardless of its questionable veracity, is there a chance you’d be more likely to believe the proclamation simply because you’ve heard it often and recently?
Like it or not, the answer is an emphatic “Yes.”
You and I are more likely to believe something is true when it’s readilyavailable—that is, when we’ve heard it frequently and, especially, when we’ve heard it lately. This phenomenon is dubbed the “availability heuristic,” and even though it was discovered and named (by Amos Tversky and Daniel Kahneman) more than 40 years ago, it likely hasn’t caught on in the broader public awareness because its title includes the word “heuristic.”
Nonetheless, the availability heuristic’s power to persuade is not lost on marketers, salespeople, lobbyists and politicians. They use it on us all the time. But let’s explore the errant biases in investing, in particular, that while readily available often lead to sub-optimal outcomes.
Active vs. Passive
The debate rages (and no doubt will continue to do so) over whether active stock pickers are able to beat their respective benchmark indices. The implications seem simple: If fee-charging money managers aren’t persistently outperforming their benchmarks, we likely should not be paying them for underperformance, right?
If you knew, for example, that nine out of 10 active managers failed to beat their benchmarks over the short and long term, would you be likely to put your money at risk trying to find the one that might add value by capturing that elusive alpha? Well, that’s what the numbers say in the newly released SPIVA U.S. Mid-Year 2016 report. Roughly 90% of professional money managers don’t “beat the market.”(Additionalstudies suggest that today as few as 2% of active managers provide statistically significant alpha.) Yet thevast majority—about 80%—of our dollars in mutual funds alone (not to mention all of the individually and separately managed stock accounts) are actively invested.
Why? Two primary reasons: First, as my colleague, Larry Swedroe, writes, “It’s not that the game is impossible to win” (inspiring hope in the gamblers among us that they’ll be the one out of 10 to beat the market) but “that the odds are so poor that it’s not prudent to try.”
But I believe there’s an even bigger reason for active management’s continued existence, and that it’s rooted in the availability heuristic. When was the last time you saw a commercial for a brokerage firm, bank or insurance company? They’re ubiquitous. I ask because virtually every single one that I’ve seen invites your investment with some variation of active management.
And there may be an even stronger force than the availability heuristic at play here—the self-preservative instinct. Tens of thousands of Americans make their living convincing people that they are (or can find) the needle in the investing haystack. That can be a powerful draw indeed to fearful investors unacquainted with the data.
Annuities
Fewer people make their living selling annuities, which are investment vehicles created by insurance companies, but their motivation to move products is even greater thanks to some of the highest commissions in financial sales. That’s why it has often been said that “annuities are sold, not bought.”
I must add that there are valid uses for certain types of annuities in certain situations, but many, if not most, of the uses encouraged by much of the industry have been academically invalidated. Their proliferation seems grounded in the fact that they are so eagerly made available.
Compounding the effectiveness of the annuity sales pitch is that they are often presented as instruments that protect an investor’s principal, some even claiming to offer the upside of “the market” without its downside. Despite its too-good-to-be-true ring, the theory of loss aversion—that the pain of a loss is twice as powerful as the joy of an equal sized gain—leads many hopeful investors down a road of contractual complexity, uncertainty and illiquidity.
But with academics and much of the media sending a current of condemnation, insurance companies (and various intermediaries who share in commission overrides) need to create a perpetual cycle of availability while reminding their salesforce that they’re doing the right thing. I’ve seen this at work, in person, at a lavish annuity conference where the attendees were knighted as “the safe-money experts.” Early and often.
Life Insurance as an Investment
Similarly, the draw of high commissions leads many to tout the investment benefits of life insurance. Just last week, a thoughtful reader implored me to consider that whole life insurance can be manipulated to offer a better investment alternative than a 401(k) or IRA. For that, I blame those who’ve pounded this twisted logic into the investing public, all while dangling a very attractive carrot.
Conclusion
As consumers and investors, it’s helpful to defend ourselves with the same behavioral psychology the securities industry is using to sell things to us. And in this case, better understanding the availability heuristic also means better understanding ourselves.
This commentary originally appeared September 30 on Forbes.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE
Online peer-to-peer (P2P) lending is emerging as a provider of credit to individuals as well as small businesses, with the potential to benefit borrowers (by reducing the high cost of bank credit, credit card debt and payday loans) and lenders (by providing opportunities to earn higher yields).
A significant hurdle for investors, however, is the information asymmetry between the borrower and the lender. The lender does not know the borrower’s credibility as well as the reverse. Such information asymmetry can result in adverse selection.
Financial intermediaries have begun to replace individuals as the lenders, buying loans from originators such as the Lending Club, Prosper, Square and SoFi, and creating investment products such as closed-end “interval” funds that individual investors can use to access the market. These funds are not mutual funds, because they don’t provide daily liquidity. Instead, they provide for redemptions (with limits) at regular intervals (such as quarterly).
Reducing Asymmetric Information Risk
This type of financial intermediary can help reduce the asymmetric information risk by setting strong credit standards (such as requiring a high FICO score), performing extensive due diligence on the originators (to make sure their credit culture is strong), structuring repayments in ways that can improve performance (such as requiring that all loans be fully amortizing and that automatic ACH repayments are made, thereby eliminating the choice of which loans to pay off, as with credit card debt), and requiring the originator to buy back all loans that are shown to be fraudulent.
Additionally, they can enhance credit quality by requiring the use of social media to confirm information on the credit application. By improving transparency, they also facilitate the flow of capital to borrowers in a more efficient and dependable manner.
Riza Emekter, Yanbin Tu, Benjamas Jirasakuldech and Min Lu contribute to the literature with their 2015 study, “Evaluating Credit Risk and Loan Performance in Online Peer-to-Peer (P2P) Lending,” which appears in Applied Economics. They analyzed the data from the Lending Club, one of the largest providers of peer-to-peer loans. The database consisted of more than 61,000 loans, totaling more than $700 million, originated by the Lending Club in the period May 2007 to June 2012. Almost 70% of loans requested were related to credit card debt or debt consolidation. The next leading purpose for borrowing was to pay home mortgage debt or to remodel a home.
Key Findings
Following is a summary of the authors’ findings:
The authors found that in the case of the Lending Club, the majority of borrowers (82%) had FICO scores between 660 and 749 (a score below 650 is considered low, a score between 650 and 750 is medium and above 750 is high) compared with 28% of the U.S. national average. About 80% of Lending Club borrowers fell into medium FICO score range, and they eliminate the one-third of borrowers who make up the riskiest population.
Diversification Benefits
Note that the authors’ findings on credit risk are consistent with those of Zhiyong Li, Xiao Yao, Qing Wen and Wei Yang, authors of the March 2016 study “Prepayment and Default of Consumer Loans in Online Lending.” They too found that default can be accurately predicted by a range of variables. The authors noted that there is increased prepayment risk on these loans, because the lenders don’t charge any early prepayment penalties.
However, if the lender requires that all loans be fully amortizing, and none are long-term (typically three- to five-year maturity), duration risk is relatively small. And, of course, loans that prepay have eliminated the risk of a later default.
In addition to relatively higher yields with relatively short durations, these loans also provide some diversification benefits. The reason is that their correlation with the equity markets tends to be low, except during periods of economic distress (such as the global financial crisis of 2008) when unemployment rises.
For example, over the first two months of 2016, equity markets experienced significant losses. However, there was no downturn in the economy that would have caused consumer defaults to rise. Investors saw the same thing following the “Brexit” vote in June.
Dampening Portfolio Volatility
In both cases, while equity markets were falling, the performance of these loans was unaffected. Thus, there are times—though not all times—when an investment in these loans will help to dampen portfolio volatility.
In addition, there are benefits to buying a portfolio of consumer loans that is diversified by geography (by states and even countries) as well as by profession/industry. For example, the ability of a dentist in London to pay back a loan versus a retailer in New York is likely to have a low correlation. Even within the U.S., states each possess a microeconomy that doesn’t necessarily move in tandem with others (for example, the recent oil price declines only impacted a few areas).
It is important to understand that consumer credit is somewhat different than corporate credit. There are examples of recessions that affected corporate balance sheets while consumer credit performed relatively well (with 2001 being a recent example).
Two Other Considerations
We have two other issues to consider. The first issue is asset location. Given that all the income from these investments will be ordinary, and taxed at the highest rates, investors should prefer to hold this asset in tax-advantaged accounts.
The second issue involves what should be the main role of fixed income in a portfolio: dampening the risk of the overall portfolio to acceptable levels.
While, on average, the correlation of this asset to stock risk is low, the correlation will still rise sharply during economic downturns as credit losses increase. Thus, unless an investor has a very low equity allocation, and also has both the ability and willingness to accept more risk, the allocation to this asset should be taken from the portfolio’s equity portion.
Until now, most investors have not had direct access to the consumer and small business credit risk premium. Today with the proper controls in place, investing in consumer direct loans can offer an attractive complement to a fixed-income portfolio. While they do entail incremental credit risk, they also currently provide sufficiently high yields to allow for high expected returns (after expected default losses) relative to other alternative investment strategies and they reduce the need to take duration risk, trading off to a degree one risk for the other in the portfolio.
My position that these assets could be worthy of consideration may seem contrary to my longstanding recommendation that one should limit fixed income to the safest investments (such as Treasurys, government agencies, FDIC-insured CDs and municipals rated AAA/AA that are also general obligation or essential service revenue bonds).
Corporate Risk Gone Unrewarded
The reason for that recommendation is that the research shows corporate credit risk has not gone well rewarded, especially after considering fund expenses. In this case, however, while these assets are not of the same quality as the aforementioned safe bonds, the evidence shows that investors have been well rewarded.
Until recently, the general public had no access to these investments. They instead resided on the balance sheets of banks and other lenders. Fintech firms seem to have disrupted that model, and investment management firms have now provided access to investors.
That said, due to the credit risk of these assets, investors should be sure to perform strong due diligence on any provider to ensure they are delivering access to only the higher-quality loans in this category, that they have a strong team in place performing a high level of due diligence in determining which originators they will buy assets from, and then that they persistently monitor loan quality.
This commentary originally appeared September 28 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE