Behaviouralising Finance
Anxiety Adjusted Returns
Greg B Davies, PhD
Head of Behavioural Finance
May 2013
Unrestricted distribution
2
Sell date, quarterly 70
75
70
80
85
90
95
00
05
10
If you bought in 1975
and sold in 1995, your
average annual return
would have been 12%
Buy date, 75
quarterly
80
85
MSCI World
Equity
Annualised
Returns
90
95
00
05
Past performance is not a reliable indicator of future results
<-5%
-5% to
0%
0 to
5%
5 to
10%
10 to 15%
Source: MSCI World Index, 1970 - August 2011, Barclays Wealth
>15%
10
Sell date, quarterly 70
75
70
80
85
90
Buy date, 75
quarterly
95
00
05
10
No nominal losses over
any holding period of
12 years or more
80
85
MSCI World
Equity
Annualised
Returns
90
95
Zone of Anxiety
00
05
Past performance is not a reliable indicator of future results
<-5%
-5% to
0%
0 to
5%
5 to
10%
10 to 15%
Source: MSCI World Index, 1970 - August 2011, Barclays Wealth
>15%
10
The experience we should base decisions on
60%
40%
20%
0%
-20%
-40%
Framing horizon
Source: MSCI World Index, 1970 - August 2011, Barclays Wealth
Past performance is not a reliable indicator of future results
Dec-11
Dec-10
Dec-09
Dec-08
Dec-07
Dec-06
Dec-05
Dec-04
Dec-03
Dec-02
Dec-01
Dec-00
Dec-99
Dec-98
Dec-97
Dec-96
Dec-95
Dec-94
Dec-93
Dec-92
Dec-91
Dec-90
Dec-88
Dec-87
Dec-86
Dec-85
Dec-84
Dec-83
Dec-82
Dec-81
Dec-80
Dec-79
-80%
Dec-89
10 Years
-60%
The experience we do base decisions on
60%
40%
20%
0%
-20%
-40%
Framing horizon
1 Year
-60%
10 Years
Source: MSCI World Index, 1970 - August 2011, Barclays Wealth
Past performance is not a reliable indicator of future results
Dec-11
Dec-10
Dec-09
Dec-08
Dec-07
Dec-06
Dec-05
Dec-04
Dec-03
Dec-02
Dec-01
Dec-00
Dec-99
Dec-98
Dec-97
Dec-96
Dec-95
Dec-94
Dec-93
Dec-92
Dec-91
Dec-90
Dec-89
Dec-88
Dec-87
Dec-86
Dec-85
Dec-84
Dec-83
Dec-82
Dec-81
Dec-80
Dec-79
-80%
Modern Portfolio Theory – the standard model
Expected
Returns
Portfolio Efficient Frontier
Risk/Return Trade-off
(Indifference Curve)

7
A completely rational, risk-averse, investor…
Long-term Objectives
Utility
Perceived
Value
8
A completely rational, risk-averse, investor…
Short-term Biases
Perceived
Value
Losses (%)
9
Long-term Objectives
Utility
Gains (%)
Behaviour
Utility
Perceived
Value
Losses (%)
Gains (%)
Adding anxiety…
Short-term Biases
Perceived
Value
Losses (%)
10
Long-term Objectives
Utility
Gains (%)
Behaviour
Utility
Perceived
Value
Losses (%)
Gains (%)
Anxiety leads investors to reject beneficial investments
Risk plus Anxiety
Compensation
Expected
Returns
Accept
Falsely
Reject
Risk
Compensation
Anxiety
Compensation
Reject
Risk free
return
Risk
12
DESIRE FOR DELEGATION
DESIRE FOR DELEGATION
BELIEF IN SKILL
PERCEIVED FINANCIAL EXPERTISE
PERCEIVED FINANCIAL EXPERTISE
Risk Attitudes
BELIEF IN SKILL
MARKET ENGAGEMENT
MARKET ENGAGEMENT
COMPOSURE
RISK TOLERANCE
RISK TOLERANCE
COMPOSURE
Mr. Jones
Mrs. Jones
Fine-tuning the individual solution
Decision Style
Moderate Risk Tolerance
?
?
Portfolio Return
Buy emotional comfort the easy (and expensive) way
Time
13
Portfolio Return
Buy emotional comfort the easy (and expensive) way
Reluctance
Time
14
Portfolio Return
The journey matters!
Danger of buying high
Danger of selling low
Behaviour
Gap
Time
15
Portfolio Return
The journey matters!
Buying Emotional Insurance through Smoothing
Emotional
Insurance
Behaviour
Gap
Time
16
Maximising Anxiety Adjusted Returns
Expected
Returns
Portfolio Efficient Frontier

17
Contact Details
greg.davies2@barclays.com
@GregBDavies
InvestmentPhilosophy.net
Unrestricted distribution
Portfolio Return
Which investor is happiest at the end?
A)
B)
C)
D)
Blue line
Black line
Orange line
None/all
Time
19
20
BELIEF IN SKILL
DESIRE FOR DELEGATION
DESIRE FOR DELEGATION
Risk Attitudes
BELIEF IN SKILL
PERCEIVED FINANCIAL EXPERTISE
PERCEIVED FINANCIAL EXPERTISE
COMPOSURE
COMPOSURE
MARKET ENGAGEMENT
RISK TOLERANCE
RISK TOLERANCE
MARKET ENGAGEMENT
Mr. Jones
Mrs. Jones
The traditional asset allocation solution
Decision Style
Moderate Risk Tolerance
Cycle of investment emotions
Exuberance
Excitement
Denial
Optimism
Fear
Reluctance
Reluctance
Desperation
Panic
Capitulation
Indifference
Apathy
Depression
Despondency
21
Reluctance: waiting for the right moment
Cumulative Returns - Indexed
250
200
150
100
50
0
Jan-02
Jan-04
Jan-06
SAA RP3
Source: FactSet, Bloomberg, Merrill Lynch and Barclays.
22
Jan-08
Jan-10
3M LIBOR
Jan-12
Reducing anxiety
Category
Reluctance
Behaviour Gap
+
+
-+
+
+++
++
+
+
+++
++
Discretionary management
+
+++
Involvement
Advice
+
+
Trading-off efficiency
Reduce information frequency/detail
Increase liquidity
Familiarity bias
Deliberate action bias
Active versus passive
+
+
++
+
+
++
+
+
+
+
Strategic versus tactical
+
+++
+
+++
Education
Constraints
Risk targeting
Management style
Investing framework
23
Action
Lock in to low liquidity assets
Reduce Risk
Smoothing
Downside defence
Phased investment
Financial framing – instability of risk preferences
Imagine you bought $6,000 worth of stock from a now bankrupt company
There are two alternatives to recover money…
Would you choose A or B?
Alternative A
 Recover $2,000
Alternative X
 Lose $4,000
Alternative B
 1/3 chance $6,000 recovered
 2/3 nothing recovered
Alternative Y
 1/3 chance nothing lost
 2/3 chance $6,000 lost
92% go for A
Source: Wang, 1996
24
24
Would you choose X or Y?
67% go for X
25
Disclaimer
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