Biological Basis for Errors in Risk Assessment

October 2009









































Biological Basis for Errors in Risk Assessment 1


Two differing schools of thought dominate current thinking about the stock market: One follows the
teachings of University of Chicago professor Eugene Fama, who in the 1960s introduced the efficient
market hypothesisthe idea that stock prices reflect all publicly available information. More recently, a
new generation of scholars has begun to question the universality of Famas teachings, suggesting that,
in the short term at least, stock markets indeed are less than fully rational and that analysis of past
behaviors can help anticipate the future direction of the marketthe premise fueling research in the field
of behavioral finance.

The assessment of risk has an important role in investment management, and plan sponsors remain
keenly aware of the risk level of their total portfolio, as well as the risk level for each individual manager
within the total plan. Likewise, investment managers themselves consider the overall risk of the portfolios
they manage for plan sponsors. And while it is important to know the portfolio-level risk, it is critical that
this risk be assessed correctly in order to yield meaningful results. Herein lies one of the great challenges:
are investors analyzing risk correctly or are they falling victim to incorrect risk assumptions that lead to
sub-optimal (irrational) decisions? If the latter, what can be done to overcome this?

A great deal of research in recent years suggests that our risk assessment is flawedthat is, that
humans make errors in judgmentbecause we are biologically programmed to respond to some risks in
certain ways. Behavioral research has shown that most of the incorrect decisions made by investors stem
from overconfidence. This paper will detail some of the most common errors in judgment, explore how the
field of neuroscience is working to explain why investors make these errors in assessing risk, the brains
response to risk and then, ultimately, how a quantitative approach to investing can help overcome human
errors in risk assessment.
Biological Basis for Errors in Risk Assessment 2


Contents


I. Common Human Errors in Judgment

II. How the Brain Responds to Risk

III. Can Quantitative Investing Overcome Flawed Risk Assessment and Biology?

IV. Quantitative Investing at OFI Institutional One Managers Experience

V. Conclusions

Notes

Biological Basis for Errors in Risk Assessment 3


I. Common Human Errors in Judgment

A 1974 article titled Judgment Under Uncertainty: Heuristics and Bias, by Israeli psychology professors
Amos Tversky and Daniel Kahneman, noted that in making decisions involving probability and risk,
people rely on mental shortcuts that are highly economical and usually effective but lead to systematic
and predictable errors.
1
So, let us begin by looking at some of the most common errors in assessing risk.

Gamblers Fallacy

Individuals who believe in the gamblers fallacy believe that after three red numbers appearing
on the roulette wheel, a black number is due, that is, is more likely to appear than a red
number.
2

Sundali and Croson (2006)

Gamblers fallacy is a false belief that the probability of a random event, in a sequence of events, is
dependent on what happened in the preceding events. Said another way, victims of gamblers fallacy
believe that observations in a random process are expected to be evened out by opposite deviations in
future observations. The most commonly cited example of gamblers fallacy is a coin toss. If the coin is
tossed one time, a result of heads or tails is equally likely. Each and every additional toss of the coin is
subject to the same odds. However, what happens if the coin has been tossed five times, with heads the
result each time? Does this mean that logically, because the chance of a streak of six consecutive heads
is low, the next result is more likely to be tails? If you answered yes to this question, you have fallen
victim to the gamblers fallacy. In reality, regardless of what happened on the previous five tosses, there
is the same chance that the result will be heads as there is that it will be tails on that sixth toss.

In their 1974 work, Tversky and Kahneman noted that after observing a long run of red on the roulette
wheel, for example, most people erroneously believe that black will result in a more representative
sequence than the occurrence of an additional red.
3
The researchers concluded that people tend to
believe that short sequences of random events (the next roll of a die, spin of a roulette wheel, etc.) should
be representative of the longer ones. In the long-term, people expect that these short-run deviations will
revert back to the meana more equal breakdown between heads and tails, red and black.

Investors who believe the market will move lower after a period of rising returns or move higher after a
period of falling returns fall victim to the gamblers fallacy. Even the most skilled investment managers
cannot pinpoint the exact date on which a bull or bear market will end. Consider this: While the average
bull market lasts nearly five years, the longest bull market in the post-World War II era lasted over nine
years. By moving out of the markets too early, investors would have missed a significant period of growth
for domestic equities.

Compare this hot outcome expectation of trend reversal to the hot-hand expectation of trend
extension, below.

Hot-Hand Fallacy

Hot hand is different from hot outcome. Rather than believing that a particular outcome is hot,
individuals who believe in the hot hand believe that a particular person is hot.
4

Sundali and Croson (2006)

Biological Basis for Errors in Risk Assessment 4


Whereas the odds are known in the gamblers fallacy, the hot-hand fallacy applies to streaks where the
odds are not known. Imagine a professional baseball player that has gotten a hit in his last three at-bats
or a home run in each of the last ten games played. Observers are left to wonder how likely it is that the
player will get a hit his next at-bat or hit a home run in his next game. Statistically speaking, the odds are
no greater than if he had not had a hit or home run for some time. Hersh Shefrin writes in his 2007 work,
Behavioral Finance: Biases, Mean-Variance Returns, and Risk Premiums, that the idea that streaks have
predictive power is an illusion: representativeness, the human tendency to discern a pattern (even where
none may exist) is what leads us to extrapolate recent performance.
5


Gilovich, Vallone, and Tversky (1985) found that virtually everyone has some belief in the hot hand.
6
Their
research, which focused on professional basketball, found that 91 percent of fans thought that a player
had a better chance of making a shot after having just made his last two or three shots. Moreover,
68 percent thought the same for free throws. To test whether the hot hand actually exists, Gilovich et al.
looked at team shooting percentages over an entire season. Their research showed that the proportion of
shots hit was in no way related to the number of previous shots in a row a player had either hit or missed.
Analysis of the data demonstrated that successful and unsuccessful runs for each player were not
significantly different from the number of expected runs given the players overall shooting percentage
and assuming that all shots were independent of each other. The conclusion: [B]elief in the hot hand is
not just erroneous, it could also be costly.

Both the gamblers and hot-hand fallacies can be observed in the investing publics behavior. Rachel
Croson and James Sundali, in their 2005 piece, The Gamblers Fallacy and the Hot Hand: Empirical Data
from Casinos, wrote that it has been argued that the disposition effect in finance (the tendency of
investors to sell stocks that have appreciated and hold stocks that have lost value, discussed in depth
below) is caused by gamblers fallacy beliefs other evidence demonstrates that consumers mutual fund
purchases depend strongly on past performance of particular fund managers (Sirri and Tufano, 1998),
even though the data suggests that performance of mutual fund managers is serially uncorrelated (e.g.,
Cahart, 1997). Thus individuals are presumably making investment decisions based upon the belief that
particular funds or fund managers are hot.
7


Interestingly, the gamblers fallacy and the hot-hand fallacy work in opposite directions: the first stipulates
that streaks or deviations reverse quickly while the latter assumes that trends will extend. Thus is the
subtle and quixotic nature of our behavioral biaseswe reach opposite conclusions about similar patterns
depending upon how they are framed. We discuss framing errors in greater detail later in this article.

Disposition Effect

When an individual investor sells a stock in his portfolio, he has a greater propensity to sell a
stock that has gone up in value since purchase than one that has gone down.
8

Barberis and Xiong (2009)

Research has shown that investors tend to hold losing stocks too long and to sell winning stocks too
early. In assessing holdings within a portfolio, investors are emotionally affected by whether a stock was
purchased for more or less than its current price. Considering an investors reluctance to sell a stock that
has declined in value, Statman and Shefrin (1985) concluded that people avoid selling a stock that has
gone down in value in order to avoid the pain and regret of having made a bad investment choice; this
phenomenon has been termed the disposition effect.
9


Biological Basis for Errors in Risk Assessment 5


Tversky and Kahnemans prospect theory, which describes how people make choices in situations where
they must decide between alternatives that involve risk, offers a simple understanding of the disposition
effect: If an individual investor is risk-averse over gains, that investor should be inclined to sell a stock
that is trading at a gain.
10
If the investor is risk-seeking over losses, the expected course of action would
be to hold a stock that is trading at a loss. Given the relationship between risk-averse and risk-seeking
behaviors and trading activities, researchers have concluded that investors are more willing to assume
risk with a security that has an unrealized loss than one with an unrealized gain and thus are more
inclined to sell the latter. Said another way, investors often (and often incorrectly) assume that the stock
that has declined in value is more likely to revert back to (at least) its original purchase price rather than
continue to decline in value.

In his 1998 paper Are Investors Reluctant to Realize Their Losses, Terrance Odean studied 10,000
accounts at a large brokerage house and found that, overall, investors were more likely to realize gains
than losses in their accounts.
11
While he found that some movement occurred in late December as
investors sought to capture tax-related benefits, to rebalance portfolios, or to trade in consideration of
transaction costs, his research suggested that once the data were controlled for rebalancing and for
share price, the disposition effect remained. Further, the winning stocks that investors chose to sell, in
subsequent months outperformed losing investments that remained in the portfolio by an average of 3.4
percent. In fact, Odeans research showed that, on average, winning stocks that were sold tended to
outperform the losers that were not sold over the next six to twenty-four months.

The disposition effectthis tendency to hold on to losing stocks to a greater extent than to winning
stocksprovides a rationale for why momentum factors often tend to be an effective tool in making
investment decisions. If investors are inclined to sell their winning stocks, without regard to the earnings
or other fundamental considerations, their selling applies a downward bias to the stocks price. That is,
absent this emotion-driven selling, the stocks price would be higher than its current market price.
Conversely, if investors are reluctant to sell losing stocks, again without regard to underlying
fundamentals, then their lack of selling exerts an upward bias on the stocks price. In other words, absent
the disposition effect, investors would be more likely to sell their losing stocks, which would have the
effect of pushing the stock price below the market price. So, whether a stock is rising or falling in price, a
strategy of following the momentum (buy the winners, sell the losers, sometimes summarized as the
trend is your friend) can be justified due to the disposition effect.

Interestingly, financial research has shown that the disposition effect is observable over horizons of six to
fifteen months. For horizons shorter than six months, price momentum has a tendency to reverse, with
the reversal effect more powerful as the horizon shortens. This effect is likely due in part to investor over-
reaction: when good (bad) news on a firm is released, investors rush to buy (sell) with insufficient regard
to the change in the stocks price; the result is that the price is ultimately pushed too high (low) and a
reversal occurs. For longer horizons, say, of two years or more, price momentum also has a tendency to
reverse. Viewed in terms of behavioral finance, this phenomenon is the result of the buying pressure of
investors following the hot-hand fallacy outweighing the selling pressure of investors following the
disposition effect over a sufficiently long horizon. Eventually, the trend-following investors drive the stock
price too far, high or low, with a reversal ultimately following.

Quantitative investment managers often make use of multiple factors which try to capture these varying
aspects of momentum and reversal. OFI Institutional, for example, employs two Price Momentum factors
as well as two Price Pullback factors. The former are purely momentum factors, designed to capture the
disposition effect. The latter are multi-faceted, trying to capture reversal and momentum effects. Detailed
descriptions of these, and every other factor used by OFI Institutional, are available in the publication OFII
Library of Factors.
Biological Basis for Errors in Risk Assessment 6


Base-Rate Neglect

The Base Rate Fallacy is the belief that probability rates are false. When presented with
statistics about the population as a whole, people tend to ignore them and think about themselves
as completely different entities.
12
Elliott (1996)

Base-rate neglect (or fallacy)another example of flawed risk assessmentexplains how in making
inferences regarding probability in the presence of specific scenario information, people tend to ignore
generic information. In order to gain a better understanding of the principle, let us review a commonly
cited example of base-rate neglect. Imagine that you visit your family physician because you are
concerned that you have contracted a disease found in one out of a thousand people in the general
population. To better determine whether you have in fact contracted the disease, the doctor orders a test
with an accuracy rate of 95 percent. If the test result comes back positive, what are the chances that you
really have contracted the disease?

Most people (and physicians) would incorrectly assume that in the above scenario there is a 95 percent
chance of having the disease, given the positive test result. However, this assessment fails to consider
the possibility that the test result is wrong, i.e., showing a false positive. This intuitive but erroneous
conclusion fails to consider the rate of incidence, or base rate, when evaluating probability. In actuality,
there is less than a two percent chance that you have contracted the disease.

To better understand this, we must briefly turn to Bayes theorem, which says that the conditional
probability (i.e., the probability of event X given event Y) is the ratio of the probability of both events X and
Y occurring to the probability of event Y occurring for any reason. In our example, the probability of being
sick, given a positive test result, is the probability of being sick and receiving a positive result divided by
the probability of receiving a positive result for any reasoni.e., a true or false positive.

To calculate Bayes theorem, we must have the following information:
P(S): probability that you are actually sick (1 out of 1,000 or 0.001)
P(N): probability that you are not sick ([1-0.001] or 0.999)
P(A): probability that the test is positive and you are sick (95 percent accuracy or 0.95)
P(I): probability that the test is positive and you are not sick ([1-0.95] or 0.05)

Bayes theorem:
[P(A) x P(S)]
[P(A) x P(S)] + [P(N) x P(I)]

[0.95 x 0.001]
[0.95 x 0.001] + [0.05 x 0.999]

In the above equation, the numerator represents the probability that the test is accurately identifying an
individual who has contracted the disease (a true positive), while the denominator represents the total
number of true and false positive results expected with the test. Carrying out the calculation reveals just a
1.87 percent chance of having contracted the disease if the test result is positive. While the odds are low,
this 2 percent chance is nevertheless much higher than the base rate, so the test has provided some
informationjust nothing close to the 95 percent certainty level that most people would assume.

Leonard Mlodinow writes of his own personal experience with this issue in his book The Drunkards Walk:
How Randomness Rules Our Lives.
13
Mlodinow recalled how both he and his wife were denied life
Biological Basis for Errors in Risk Assessment 7


insurance in 1989 based on a test of Mlodinows blood which returned a positive result for HIV. The denial
prompted Mlodinow to seek further testing, which also came back positive. His doctor was sorry to report
a 999 out of 1,000 chance that Mlodinow would be dead within a decade.

Mlodinow later learned that for the HIV test, 1 of every 1,000 samples can produce a positive result even
when the blood is not infected with the virus (i.e., a false positive). And while on the surface the odds may
seem as daunting as those quoted by his doctor, they are not. The doctor confused the chances that
Mlodinow would test positive if he were not infected with the HIV virus with the chances that he would not
be HIV positive if he tested positive. (Read that again: the order, importantly, is reversed.) The latter takes
into account the possibility of a false positive, which, as in the prior example, has a significant effect on
true probabilities.

Bayes theorem shows that the probability of event X occurring given that event Y occurred (the
probability of a positive test result given Mlodinow was not infected) will generally differ from the
probability of Y given X (the probability being uninfected given a positive test result). Studies have shown
that the failure to recognize this difference is a common occurrence not only in the medical community but
in the population at large. Mlodinow explains the importance of how this related to his own experience: if
the test had considered a narrower sampleheterosexual, monogamous, white, non-IV drug-using
Americans like himselfMlodinow claims the doctor could have developed a more accurate assessment
of the tests results. Mlodinow goes on to state that, per the Centers for Disease Control and Prevention,
the prevalence of HIV in his particular subset of the population in 1989 was 1 in 10,000.

Assuming a false-negative rate near zero, one person in every
10,000 will test positive due to the presence of the HIV virus. In
this same sample, 10 people out of 10,000 will have a false
positive for a total of 11 positive results. Instead of asserting that
Mlodinow would almost surely be dead within a decade, it would
have been more accurate to state that there was greater than a
90 percent chance that he was not infected at all. And, in fact, he
was not infected: the screening test was fooled by certain
markers that were present in his blood even though the virus for
which the test was screening was not present.

Base-rate neglect is a cognitive heuristic: a rule of thumb for
making quick judgments. We will discuss this idea in greater
detail as we examine the role that the brain plays in these errors
in risk assessment; but for now, consider that in base-rate
neglect, individuals fail to seriously consider probabilities and
base rateseven when they know they are important. This is
evident in the example above, where Mlodinows doctor failed to
consider the subset of the population that has a risk profile
closest to that of his patient.

How can the concept of base-rate neglect tie into the investment industry? In his work Behavioral Finance
and Wealth Management: How to Build Optimal Portfolios That Account for Investor Bias, Michael M.
Pompian suggests that investors, rather than perform diligent research on a company, tend to categorize
a stock as either value or growth and draw conclusions about that stocks risk and reward profile
based on that categorization. By doing so, investors can, and often do, miss important variables that
could impact the success of their investment.

10,000 people
1: 10,000
(true positive)
10: 10,000
(false positive)
11 people with
positive results
1: 11
(true positive)
9.1%
10: 11
(false positive)
90.9%
Biological Basis for Errors in Risk Assessment 8


Loss Aversion and Status Quo Bias

The central assumption of the theory (of loss aversion) is that losses and disadvantages have a
greater impact on preferences than gains and advantages.
14
Tversky and Kahneman (1991)

One implication of loss aversion is that individuals have a strong tendency to remain at the status
quo, because the disadvantages of leaving it loom larger than the advantages
15
Thaler (1992)

Another concept that comes up frequently when discussing investor behavior is the idea of loss aversion,
the tendency for people to have a much stronger preference for avoiding losses than for acquiring gains.
Through their research, Tversky and Kahneman found that individuals are much more distressed by
prospective losses than they are happy about equivalent gains.
16
In general, tend to be more reluctant to
accept an uncertain payout over a more certain, albeit lower payout. Consider the following:
In scenario A, there is an 80 percent probability of gaining $4,000, and a 20 percent
probability of gaining $0
In scenario B, there is a 100 percent probability of gaining $3,000

Although scenario A has an expected value of $3,200 [(0.8 x $4,000) + (0.2 x $0)], in experiments most
people choose the guaranteed payout of scenario B, foregoing the risk of leaving empty-handed. When
facing a loss, however, people tend to be risk-seeking, meaning a scenario with a higher expected loss
but with some chance of no loss at all is preferable to a guaranteed loss, despite a lower expected value.
Scenario C exhibits an 80 percent chance of losing $4,000; a 20 percent chance of losing $0
In scenario D, there is a 100 percent probability of losing $3,000

Given these two options, scenario C (expected value: -$3,200) and scenario D (expected value: -$3,000),
people choose scenario C by a wide margin as there is some chance they will lose nothing at all.

As world stock markets plummeted in late 2008, investors sought the safety of the U.S. Treasury market,
despite yields that were historically lowor even negative. December 2008, for example, saw one-month
T-bills selling at 0% for the first time ever, and the annualized yield on three-month T-bills fell just below
0%an indication that investors (mainly banks seeking to shore up their balance sheets as year-end
approached) preferred a slight but known loss to the risk of even larger losses that might have resulted
from staying in the equity markets. At the December auction, demand for U.S. Treasury securities was so
strong that the government could have sold four times as much as it did.

Kahneman, Knetsch, and Thaler (1990) first proposed loss aversion as an explanation for something
called the endowment effect,
17
that is, the fact that people place a higher value on a good that they own
than on an identical good they do not own. Similarly, Samuelson and Zeckhauser (1988) introduced the
concept of a status quo bias
18
in which individuals prefer things to remain the same. When valuing a
good, individuals demand a much higher price to sell it than they would be willing to pay to acquire it.

Can these theories and biases translate to the current economy, to market practices, and so forth? The
answer is yes. The housing market, for example, provides strong evidence for the endowment effect.
Shefrin states that in a normal housing market, homeowners tend to overvalue their homes by an average
of 12 percent.
19
During a downturn, such as we have been experiencing over the last several years,
sellers list their home for an average nearly one-third above fair market value.

Biological Basis for Errors in Risk Assessment 9


The status quo bias, meanwhile, plays a particularly important role in 401(k) planning, both in terms of
contributions to a plan and to the asset allocation choices for those contributions. Overall, when U.S.
employees must opt in to their employers 401(k) plan, roughly 25 percent of workers fail to sign up,
despite the fact that in many cases the employer will match some portion of employee contributions
(these non-participants effectively leave money on the table). However, participation increases
dramatically when employees must opt out of, rather than in to, the plan. Ed Ferrigno, vice president of
Washington Affairs for the Profit Sharing/401(k) Council of America, reports that when an employers plan
features automated contributions, participation increases to more than 90 percent.
20
Similar patterns can
be observed globally: countries where employees must opt out of a retirement plan show markedly higher
participation rates than in countries where employees must opt in. In the U.S., the Pension Protection Act
of 2006 addressed this issue by allowing employers to automatically enroll workers in their 401(k) plan at
a minimum default contribution of 3 percent (and allowing employees 90-days to opt out without penalty).

In another example of the status quo bias, research shows that many 401(k) plan participants enroll in the
default fund rather than making a more active decision. Dana Muir, Professor of Business Law at the
University of Michigan, notes that in a 2002 study of 401(k) plans, up to 81 percent of plan assets were
invested in a default option.
21
This means that plan providers should give careful consideration to the
default set-up. All too often, the default is a money market fund or other extremely low-risk asset class.
While such a choice provides protection against the loss of nominal principal, loss of real principal is
probablei.e., there is a good chance the low-risk choice will not keep pace with inflation, eroding the
real value of the retirement account. As directed by the Pension Protection Act, the U.S. Department of
Labor defined Qualified Default Investment Alternatives to include life-cycle funds, which help to provide
the investor an age-appropriate blend of asset classes, along with target-date retirement funds, balanced
funds, and professionally managed accounts.

Framing Errors

[P]resented with the same basic economic proposition, we make markedly different choices
depending on whether the deal gets framed in terms of loss or gain.
22
Conniff (2008)

In the assessment of risk and reward, the manner in which choices are framed can play a significant role
in decision-making. Massimo Piattelli-Palmarini, in his 1994 book Inevitable Illusions: How Mistakes of
Reason Rule Our Minds, presented the following example
23
:

Imagine that the United States is preparing for the outbreak of an unusual disease that is
expected to kill 600 people. Two alternative programs to combat the disease have been
proposed. Assume that the exact scientific consequences of the program are as follows:
If Program A is adopted, 200 people will be saved.
If Program B is adopted, there is a one-third probability that 600 people would be saved
and a two-thirds probability that no people would be saved.

In this same test, two additional possibilities were presented:
If Program C is adopted, 400 people would certainly die.
If Program D is adopted, there is a one-third probability that no one will die and a two-
thirds probability that 600 people would die.

In the above example, rational individuals should view each choice as being equal since in each scenario,
the expectation is that 200 lives will be saved. However, the manner in which each choice is presented
Biological Basis for Errors in Risk Assessment 10


evokes strong reactions that can affect decision-making. When given a choice between Program A and
Program B, respondents preferred Program A at a rate of nearly three to one, indicating risk-aversion:
people typically consider it better to save some people than to risk everyone being lost. Contrarily, given a
choice between Programs C and D, respondents chose Program D over Program C in similar numbers,
indicative of risk-seeking behavior: framed in terms of certain death rather than of saving lives, people
tend to feel it is better to try and save everyone rather than to accept 400 certain deaths.

This effect has clear implications for investment managersthe response a manager has to corporate
news is likely influenced by how the news is framed and thus interpreted by the manager. However, for a
quantitative manager, framing errors can be largely mitigated: By relying only on the result or expected
value, the change in investment opinion (if any) to the news will be the same irrespective of the manner in
which the news is either framed or received.

Noah Myers, a senior portfolio manager with Smith Barney, spoke to Richard Conniff about framing errors
in the context of a market crash. He contends that investors suffering steep declines are only able to view
their portfolio through a framework of loss.
24
Myers claims that most investors reach a point during a
crash where they give up and sell, at that point becoming much more rational and seeing the potential for
gain as the markets begin to rise again. Selling low, only to reinvest as stocks begin moving higher, can
be especially costly. Consider this: No one knows for sure when a down-market has turned positive until
well after the fact, and missing even a few days of an up-market can dramatically affect performance.

Looking at the first few trading days of the complete post-World War II market cycles underscores this
point: The average absolute price-only return of the S&P 500

Index for the first 20 trading days of each

new bull leg (including the apparent bull market that began on March 9, 2009) is 11.8%significantly
better than the annualized 9.6% total return of common stocks for the last 83 years, from 1926 through
2008.

Recency Effect

Given a list of items to remember, we will tend to remember the last few things more than those
things in the middle.
25
Changingminds.org (website)

From a psychological perspective, the recency effect is found when subjects are able to recall items from
the end of a list more readily than from its beginning and is considered a reflection of short-term memory.
In finance, the recency effect also relies on short-term memory and stands in direct opposition to the
gamblers fallacy (a false belief that the probability of a random event, in a sequence of events, is
dependent on what happened in the preceding events). Also referred to as availability, it has been used
to explain distortions in frequency or probability judgments.

Simply put, the recency effect refers to a phenomenon in which recent events carry more weight. For
example, people tend to buy earthquake insurance immediately after an earthquake; however, as time
passes, fewer people are inclined to purchase protection. This is in direct contrast to scientific reasoning:
immediately after an earthquake, one is unlikely to experience another, but the odds increase the more
time has passed since the last one. Similarly, bear markets may push investors to safer alternatives even
though much of the downside risk to equities may have already passed.

Keep in mind that late in a bear market is perhaps the time when a plan sponsor is most susceptible to
holding a lower than normal equities exposure. Admittedly, it can be difficult to see beyond the tumult of
Biological Basis for Errors in Risk Assessment 11


late; the recency of market events weighs heavily on investors, but it is critical to maintain a long-term
perspective. The most recent bear market, which likely ended in March 2009, was just two months longer
than the post-World War II average of nearly 15 months. It was the most costly of the recent bear
markets, with a total decline of -56.8% (the 2000-02 decline of -49.1% had previously rated most costly).

For investors that pulled out of the market, or delayed rebalancing their equity ratio (upward), there was
much to be lost. Consider this:
The average price-only return for the first 20 trading days of the latest bull leg was 24.5%
significantly higher than the annual total return of common stocks (9.6%) dating back to 1926.
Missing the first 20 trading days (on average only 2.5 percent of the total trading days for each
bull leg) means missing an average 12.4 percent of the total return for the entire bull leg.

In effect, each of the first 20 trading days of a bull market are, on average, nearly four times more
productive than each of the remaining 1,100 days (nearly 4.25 years).

Mispricing of Risk

The efficient market hypothesis states that prices on traded assets such as stocks and bonds reflect all
known information; consistently outperforming the market using information that is already known is
impossible. Testing the efficiency of the markets is difficult, however, because a stock is considered to be
a perpetual assetits value depends not just on the present value of its future cash flows but also the
price someone would be willing to pay to acquire that stream of future cash flows. Richard Thaler argues
in The Winners Curse: Paradoxes and Anomalies of Economic Life that wagering markets, such as
horseracing, have a better chance of being efficient: these markets have a short time horizon, offer
repeated feedback, and have a well-defined termination point at which potential value becomes certain.
26

It is this type of market that provides an opportunity to examine the mispricing of risk in more detail.

For illustration, we will follow horseracing in our examination of mispriced risk
and the wagering market. While there are both simple and complex ways in
which to place bets (win, place, or show versus daily double, exacta, trifecta,
and so on), what is important to know is that payoffs for all winning bets are
determined in a pari-mutuel fashion. Simply put, all bets of a particular type
are placed together in a pool, transaction costs are deducted, and payoff odds
are calculated by sharing the pool among all winning bets.

The free, online encyclopedia Wikipedia provides a basic example of pari-
mutuel betting, detailing a hypothetical event with eight possible outcomes,
each with a certain amount of money wagered as shown to the left. In
horseracing, the proportion of money in the win pool that is bet on each
horse can be interpreted as the subjective probability (corresponding to a
personal belief) that each horse will win the race. James Surowiecki, author of
The Wisdom of Crowds, cites four qualities that make the crowd smarter: diversity, decentralization,
independence, and a way to summarize peoples opinions into one collective verdict.
27
Horseracing offers
a great laboratory to study this wisdom of crowds: while a good public handicapper will pick about 30
percent of the winners each year, the public picks roughly 33 percent.

The expected payout in horseracing, or any event using pari-mutuel betting, is simply a function of the
collective opinion of the bettors. Returning to our Wikipedia example, the total pool for this event is $514.
Assume outcome #4 is the winner, with $55 wagered. To calculate the payout, transaction costs (in this
case a commission of 14.25%) are first deducted, leaving $440.76.


Outcome
Amt.
Wagered
1 $30.00
2 $70.00
3 $12.00
4 $55.00
5 $110.00
6 $47.00
7 $150.00
8 $40.00
Biological Basis for Errors in Risk Assessment 12


The amount remaining in the pool after transaction costs is distributed to those
who wagered on outcome #4. $440.76/$55 = $8.00 per $1.00 wagered. With
$7.00 in profit for each $1.00 bet, the odds are considered 7-to-1. The
expected payout for each outcome is shown to the right. In this type of market,
participants ultimately determine the risk level. But what happens when
participants misprice the inherent risk of the bet? Steven Crist, publisher and
columnist for the Daily Racing Form spoke at Legg Mason Capital
Managements Thought Leader Forum in September 2007. During his lecture,
he recalled the spring of 2004 when Smarty Jones emerged as winner of the
Kentucky Derbyand thus the only horse eligible to win that years Triple
Crown.
28
The horse went on to win the Preakness by an astonishing twelve
lengths. As Crist recalled, the world went absolutely crazy, and anticipation
was high that Smarty Jones would win the first Triple Crown since 1978.

After taking the first two legs of the 2004 Triple Crown, handicappers considered Smarty Jones between
30 and 50 percent likely to win the final legthe Belmont Stakes. The betting public viewed things
differently, assigning even higher odds of success. More often than not, the wisdom of the crowds holds
and bettors tend to correctly value risk at the track. In this case, however, the betting public was
overwhelmingly biased toward Smarty Jones. Five out of every six dollars wagered were for Smarty
Jones to win, meaning that the public gave the horse an 83 percent chance of winning. Crist called this
one of the most fabulous opportunities in the history of betting. He said it did not matter which horse
might beat Smarty Jonesand he bet on all the other horses in the race. In the end, Smarty Jones lost to
a late-charging long-shot. For those who recognized the opportunity, a lot of money was there for the
taking: when asked what his pay-out was, Crist replied About a quarter of a years salary.

Surowiecki writes that when a group of people are biased in the same direction, the group is not likely to
make a good decision.
29
Similarly, he notes it is also detrimental when people start paying too much
attention to what others in the group think. The technology bubble of the late 1990s is just one example of
how a crowds judgment can be compromised, just as it was in the Smarty Jones case. Rather than
considering what a company was truly worth, many investors speculated on how much other investors
thought the company was worth. More recently, the run-up in housing prices from investor speculation in
the housing market is another example. In each instance, a self-reinforcing feedback loop resulted with
rising prices justifying current prices and begetting ever-higher prices. Ultimately, these feedback loops
accelerate, triggering pricing bubbles. The bubble inevitably pops, resulting in a costly correction in order
to return the markets to a more appropriate valuation point.

Outcome
Expected
Payout
1 $14.69
2 $6.30
3 $36.73
4 $8.00
5 $4.00
6 $9.37
7 $2.94
8 $11.02
Biological Basis for Errors in Risk Assessment 13


Summary of Common Errors in Judgment

Judgment
Error
Summary
Explanation
Investment
Implications
Benefits of
Quantitative Investing
Gamblers Fallacy
Belief that the outcome of a
random event, in a sequence of
such events, is at least partially
dependent upon preceding
outcomes.
Can lead to attempts to
time markets; may be
compounded by
Disposition Effect.
Decisions made based on
stock-level valuations
(bottom up), rather than
on market trends (top
down).
Hot-Hand Fallacy
Assumes a person (or series) is
hot, i.e., that a trend will
continue; humans perceive
patterns where none may exist.
The axiom past
performance is no
guarantee of future
results is ignored.
Decisions based on
quantitative factors,
typically uninfluenced by
false patterns.
Disposition Effect
Reluctance to sell something
(e.g. a house, a stock) that has
declined in value.
Prices can be artificially
supported above or
suppressed below fair
market value.
Momentum factors may
be quantitatively
exploitable in the
investment process.
Base-Rate Neglect
Failure to properly account for
conditional probabilities (e.g.,
failure to consider false
positives).
Failure to consider all
relevant information in
making investment
decisions.
Unbiased decisions based
on quantitative factors;
potentially fuller
assessment of risk.
Loss Aversion
The preference (often strong) for
avoiding losses over achieving
gains.
Can lead to unwillingness
to sell investments that
have fallen in value.
Sell decisions are
unbiased.


Status Quo Bias
Tendency, absent incentives, not
to change established behavior
(cf. Newtons first law of motion).
Selection of a safe or
default investment option
that may be unable to
meet financial objectives.
Can automatically
maintain portfolio
diversification.

Framing Errors
The manner in which choices are
phrased (or framed) can play a
significant role in the decision-
making process.
Response to corporate
news is likely influenced
by how the news is
presented or framed.
By relying only on results
or expected value of, e.g.,
a news event, investment
rankings are not directly
affected by framing.

Recency Effect
Tendency to best remember (or
give more weight to) the most
recently presented data.
Investors can be more
heavily influenced by
recent market events.
Investment decisions
based on quantitative
rather than chronological
or perceptual inputs.
Mispricing of Risk
The over- or underestimation
(often due to errors noted above)
of the risk or probability of a
particular situation or outcome;
also, to miscalculate the true
costs of possible outcomes.
When a group is biased in
the same direction, or
when an individual is
affected by the crowd,
investment decisions may
suffer.
Is intended to minimize
speculative, emotional, or
rash buy/sell orders.
Biological Basis for Errors in Risk Assessment 14


II. How the Brain Responds to Risk

It turns out that many of these errors may have a biological basisour brains undergo changes in the
face of uncertain risk and reward. Researchers can study how the brain responds to an estimate of risk
and the probability of reward via magnetic resonance imaging (MRI). MRI technology offers a detailed
look inside the body and is especially useful in studying soft tissues, such as muscle and the brain. While
society today may appear quite evolved, the brain seems to excel at the types of skills that likely would
aid survival in more primitive timessolving short-term trends or eliciting emotional responses. Humans
are less efficient when dealing with long-term patterns or multiple factorsareas of interest to investors.

So, what is happening inside our brains and how can the investment community use that information?
Before answering that question, we must first examine the areas of the brain involved in decision-making
where uncertainty, risk, and reward are concerned.

The amygdala is part of the limbic systema collection of brain structures that support such functions as
emotion, behavior, and long-term memory. The amygdala performs primary roles in the formation and
storage of memories associated with emotional events which are not limited to just threats of physical
danger, but also include areas such as financial gain and loss. A study led by Jordan Grafman, a
neuroscientist at the National Institute of Health, found that the more frequently research subjects were
told they were losing money, the more active this region of the brain became.
30
In 2001, Breiter et al.
found that even the expectation of losses set off bursts of activity inside the amygdala.
31


Further, researchers found that activity inside the amygdala can trigger the release of adrenalinethe
hormone most commonly associated with the bodys fight or flight response. This primitive response to
stress is intended to prompt action in the face of an immediate physical threat. It also serves to solidify
memories of the eventa response that can be quite costly for investors. Panicked selling, for example,
can cause investors to leave the stock market prematurely (such as at or near a market low), missing out
on the significant returns that come in the early days of a rebounding market. Similarly, Raymond Dolan
of Englands University College London has shown that financial losing streaks evoke a strong reaction in
the hippocampus,
32
another portion of the limbic system which plays a major role in short-term memory
and spatial navigation. This region of the brain helps to program our memories of fear and anxiety and
may help to explain why investors are reluctant to return to the markets following a crash, despite the
relative cheapness of securities. At this writing, despite a recent number of record or near-record losses
for the Dow Jones, S&P

, and other major indexes, many investors still remain hesitant to resume equity
investing, spurring further losses and making this among the most costly bear markets in history.

Not everything about the amygdalas response is negative. Antoine Bechara, a neurologist with the
University of Iowa, conducted an experiment in which participants played a computer card game
consisting of four decks of cards and a $2,000 pot. Players gained or lost money with each draw from the
deck. Money Magazine columnist Jason Zweig also participated. He quickly learned that there were less
risky and more risky decks to draw from. He noted that in a matter of minutes, my amygdala had already
created an emotional memory that made my body tingle with apprehension at the very thought of taking a
big risk. Among the findings of the study: Bechara noted that people with certain types of damage to the
amygdala never learned to avoid picking cards from the riskier decks. Instead, their prefrontal cortexes,
the thinking part of the brain, allowed them to sample from all decks until their money was gone.
33

The prefrontal cortex serves to carry out the executive functions of the brain. This is the area that controls
and manages other cognitive processes such as planning, abstract thinking, cognitive flexibility, rule
acquisition, and social control (social mechanisms that regulate individual and group behaviors). This
area also has the ability to store memories, draw conclusions, forecast consequences, and compare
Biological Basis for Errors in Risk Assessment 15


current and past experiences. Among other things, this region is extremely important to the making of
sound financial judgments. In a study of Vietnam veterans with cortex damage, Grafman found that
research subjects were better able to focus on short-term financial goals than were people with normal
brain function, but less able to plan for long-term goals, such as college education for their children or
even their own retirement.
34
Bechara noted that many forms of dementia (a progressive decline in
cognitive function) can begin in the prefrontal cortex,
35
perhaps helping explain why the elderly are often
susceptible to financial scams. Damage to this region impairs the ability to recognize future
consequences of financial decisions.

Other structures that play important roles in financial decision-making include the nucleus accumbens
and anterior cingulate. The nucleus accumbens is thought to be significantly involved with reward,
laughter, pleasure, addiction, and fear, while the anterior cingulate is involved with autonomic functions
(e.g., heart rate, breathing), as well as rational cognitive functions, such as reward anticipation and
decision-making. These two areas specialize in pattern recognitionsomething considered to have been
particularly important for our early ancestors but is deemed less important in todays environment.
Unfortunately, evolution has programmed our brains to look for patterns, even in places where true
patterns do not exist. Scott Huettel, a neuroscientist at Duke University, found that the anterior cingulate
anticipates another repetition after a stimulus occurs successively only twice.
36
If that repeating pattern is
broken (think winning streaks and gamblers fallacy), neurons in the insula, candate, and putamenareas
of the inner braincan generate feelings of fear and anxiety. Furthermore, the longer the pattern had
repeated previously, the more violently the brain responds when the pattern is finally broken.

What could this mean in terms of financial investing? With the prevalence of financial information on
television, in print, and on the web, even lay investors are keenly aware of both how a companys
earnings look and how Wall Street analysts view each company. Two consecutive quarters of increasing
earningsor even simply meeting analyst expectationsis enough, in this context, to establish a pattern.
Irene Kim, while at the University of Michigan, found that the more times a company beat analyst
expectations, the further its share price dropped when earnings finally fell short.
37
A shortfall after three
consecutive positive quarters led to a three percent pullback in price. Extend that outperformance to eight
quarters and share price fell an average of eight percent. The longer a firm matched the expected
performance pattern, the greater the value lost when that pattern was finally broken.

In their 2008 article Neural Antecedents of the Endowment Effect, Knutson, Wimmer, Rick, Hollon,
Prelec, and Loewenstein demonstrate that activation in the anterior insula predicts the strength of the
endowment effect discussed earlier.
38
This area of the brain activates when someone is afraid of losing
something, is in physical (or imagined) pain, or is experiencing something that person finds disgusting. If
the idea of giving something up (ones home, for instance) is considered painful, the brain assigns a
higher value to it in order to avoid the pain of loss. While researchers have studied the role of emotion
and anticipation in decision-making, little work had been done to study the influence of anticipatory neural
activity (both the nucleus accumbens and the anterior insula) on financial risk-taking.

Kuhnen and Knutson (2005) designed tasks expected to elicit a range of investment behaviors, including
risk-seeking and risk-averse choices.
39
Their study found that anticipatory neural activation may promote
irrational choice, which may help explain why investors have a difficult time selling a stock that is losing
money or facing trouble. The 2001 collapse of Enron is one example of such a phenomenon. Harry Griffin
wrote in his 2006 article Did Investor Sentiment Foretell the Fall of Enron? that an examination of option
open interest (a measure of liquidity and, hence, fear) from January 2000 through December 2001
showed that the market signaled the potential for loss a year ahead of the actual crash.
40
Yet despite this,
investors remained committed to the firms stock, which after a year of steadily falling value, became
virtually worthless as the company filed the largest corporate bankruptcy in U.S. history up to that time.
Biological Basis for Errors in Risk Assessment 16


III. Can Quantitative Investing Overcome Flawed Risk Assessment and Biology?

In the last several years, a number of studies have focused on the emotional regions of the brain and
their link to costly behaviors for investors. Studies by Lo and Repin (2002), Sanfey, Rilling, et al. (2003),
McClure, Laibson et al. (2004) and Camerer, Loewenstein et al. (2005) could lead investors to conclude
that if emotional involvement in investing is destructive, then non-emotional processes are more likely to
lead to better performance in the long run. Indeed, if ever there were an environment likely to trigger an
emotional and potentially devastating response, the market from late 2008 to early 2009 has surely been
it: continued fallout from the sub-prime mortgage meltdown has affected the global financial system;
global debt markets suffered near-paralysis as financial institutions efforts to raise and hoard cash sent
credit costs skyrocketing; world markets have been among the most volatile on record. Countless
investors have retreated from the markets as widespread panic and selling has become commonplace.

So, just how can investors protect themselves from knee-jerk reactions in these historic times? Simply
put: a disciplined, dispassionate investment approach may well be in investors best interests.

Generally speaking, a disciplined investment process can avoid many of the pitfalls in risk assessment
and a humans biological responses to risk. Not surprisingly, people have a tendency to become
overconfident in their own abilities, particularly in areas in which they have some knowledge. However,
research has shown that increased levels of confidence show no correlation with greater success.
Investment managers are not exempt: while they are consistently overconfident in their ability to
outperform the market, most fail to consistently do so. Baumeister (2003) found that under emotional
distress, people shift toward high-risk, high-payoff options, even if those options are poor choices.
41
One
place this type of behavior is often evident is the race track. Bettors often view the last race of the day as
an opportunity to recoup any losses incurred over the course of the day, leaving them more likely to
underbet the race favorite or, more importantly, overbet horses with odds that would leave a bettor ahead
for the day.

In their 1981 article Efficiency of the Market for Racetrack Betting, Hausch, Ziemba, and Rubinstein
found that people paid too little for favorites and too much for long shots.
42
They also noted that the more
money a bettor had lost, the more likely was that bettor to wager on horses with longer odds. After
examining nearly six million races over a roughly 10-year period of time, Snowberg and Wolfers showed
in their 2007 paper Explaining the Favorite-Longshot Bias: Is it Risk-Love or Misperceptions? that while
the rate of return per dollar bet in the last race of the day is somewhat lower than for all races, it is not
statistically significant. The high-risk, high-payoff option has the lowest rate of return.
43


Now, consider this phenomenon in investment management. A manager that has been experiencing a
period of underperformance likely feels increasingly pressured to produce results. In order to make up the
performance deficit, that manager may assume a higher level of risk than was initially agreed upon,
leaving the investor more vulnerable to even greater underperformance. Baumeister (2003) also found
that when self-esteem is threatened, people lose their capacity to self-regulate: attempts to prove
themselves tend to override rational thinking. Research showed that when self-regulation fails, people
may become self-defeating in ways such as taking immediate pleasure rather than a delayed reward.

One of the tenets of quantitative investing is what is often referred to as a dispassionate approach. As
we have discussed, individual investorsand even money managerscan fall victim to emotion and the
disposition effect. In essence, investors hold on to a stock too long despite the presence of sell signals
simply because they have invested a great deal of time and energy into that stock, are overconfident in
their abilities, or are reluctant to admit an investment decision was a poor one. Perhaps because of these
Biological Basis for Errors in Risk Assessment 17


elements, Enron was favored by more fundamental than quantitative managers back in 2000 and 2001. In
general, fundamental managers focus on qualitative and subjective areas, leaving a greater likelihood
that information may be misinterpreted or mistakes made. Conversely, quantitative investment
management is generally model-driven, removing human emotions from the process.

Similar to what happened near the end of the tech bubble in 2000, in this most recent bear market that
began in October 2007, we saw a high degree of volatility in day-to-day pricing, coupled with an
increased level of indiscriminate selling. In this type of environment, it is undoubtedly difficult for any
manager to perform well (with the possible exception of technical or momentum traders). While virtually
all stocks suffered in the opening months of 2009, the underlying fundamentals of many companies
remained sound, resulting in a number of undervalued companies available for those willing to enter the
market. While emotional reaction may have precluded investors from taking advantage of these
opportunities, we contend that a disciplined and dispassionate approach is better suited to long-term
outperformance.

As markets struggled, risk management moved to the forefront for many investorsan area in which one
could argue that quantitative managers have a strong edge. So-called quant shops use computer
models to seek out companies with particular risk characteristics. By applying portfolio modeling and
stock selection techniques to a significantly larger number of securities than a fundamental manager
typically can, quantitative managers are able to identify a variety of securities that, in combination, can
effectively enhance the diversification and reduce the volatility of a portfolio.

Consider the Sharpe ratio: Calculated by subtracting a risk-free rate of return from the return of the
portfolio and dividing that number by the standard deviation of portfolio returns (which measures the
volatility of the fund in absolute terms, rather than relative to an index), the Sharpe ratio indicates whether
returns are the result of good investment decisions or from excess risk. The idea of the ratio is to evaluate
the additional return received in exchange for any additional volatility resulting from holding a risky asset.

The Sharpe ratio is expressed as a raw numberthe higher the better. Investors are advised to pick
investments with higher Sharpe ratios. However, while a Sharpe ratio greater than 1.0 is considered
good, the ratio is really most useful when comparing multiple funds or managers. Quantitative managers
use a portfolio optimizer to control risk versus the benchmark. This lowers the likelihood of being in the
wrong part of the index and ultimately yields a more favorable Sharpe ratio for client portfolios.

Karl Mergenthaler reported in the January 7, 2008
edition of Pension & Investments that in the
previous five years (back to September 2002),
quantitative strategies had generated higher risk-
adjusted returns and better downside protection
than fundamental strategies.
44
Using the
eVestment Alliance universe to separate
managers into their primary investment
approach, Mergenthaler found that while
fundamental managers boasted higher relative
performance, Sharpe ratios were higher for
quantitative managers, particularly in the large-
and mid-cap segments.
Source: JPMorgan Investment Consulting and Analytics, eVestment Alliance

Biological Basis for Errors in Risk Assessment 18


IV. Quantitative Investing at OFI Institutional One Managers Experience

OFI Institutionals quantitative investment style is based on roughly 30 years of performance data and a
comprehensive research library of more than 80 valuation factors. Using a variety of factors to build a
sector-specific composite for each market sector, our Quantitative Equity team calculates a rank for each
stock in a particular sector relative to all other stocks in the same sector. Looking at the Information
Technology sector, for example, the composite emphasizes factors that indicate sustainable earnings
growth in the near to intermediate term. In contrast, the Utilities sector composite emphasizes value-
oriented factors such as Price-to-Cashflow. This does not mean that valuation is not considered in the
Technology sector or that earnings growth sustainability is not considered in Utilities. We do consider
those factors, but, in trying to prospectively determine the relative winners and losers in each sector, our
research has shown that emphasizing different types of factors in different sectors leads to a more
powerful composite ranking.

Generally speaking, we know that quantitative managers have a dispassionate approach to investing: that
computer models and solid facts drive investment decisions. Investment decisions are the result of strong
balance sheets, not simply because a stock is due to have a strong run. We have seen evidence in
recent periods that investors have been flocking toward the most downtrodden names (the gamblers
fallacy). Investors seemingly believe that these beleaguered stocks simply have nowhere to go but up. In
the first quarter of 2009 for example, American Capital, Ltd. lost more than 80% of its share value prior to
the March 9 low. With an average daily volume below seven million shares, trading surged nearly seven-
fold in early March when the stock was trading well below $1.00/share. From the market bottom through
the first quarter of 2009, the stock gained nearly 200%. While impressive on the surface, stocks such as
American Capital, Ltd. are riddled with quality issues.

Many of these large gainers, in both the large- and small-cap segments, carry a heavy debt burden or
face debt covenant issues moving forward. With an expectation that some firms will renegotiate their
debt, leading to higher interest expenses, it is critical to identify firms that will continue to struggle in the
long-term. OFIIs Interest Coverage factor is just one screening tool that may help to identify these
troubled securities: the factor measures a companys ability to meet its interest payment obligations by
evaluating forecasted annual cash flow in the coming year divided by their annual interest expense over
the trailing year. The factor prefers stocks with higher ratios over stocks with lower ratios. OFIIs Debt-to-
Equity Trend factor also evaluates a firms debt levels, calculating a regression of the trailing eight
quarters debt to equity ratio. The trend is important here: a firm with a rising trend will score lower, even if
its actual Debt-to-Equity is considered low, as rising debt levels may signal problems later on.

As you will recall, the disposition effect deals with the propensity to sell a stock that has appreciated in
value rather than selling one that has declined in value and provides a rationale for why momentum
factors tend to be an effective tool in making investment decisions. If investors are inclined to sell their
winning stocks, without regard to earnings or other fundamental considerations, their selling acts as a
downward bias to the stocks price. Thus, absent this emotion-driven selling, the stocks price would be
higher than the current market price.

Conversely, if investors are reluctant to sell losing stocks, again without regard to earnings or other
fundamentals, then their decision to hold the stock acts as an upward bias to the stocks price. In other
words, absent the disposition effect, more investors would willingly sell losing stocks, pushing the stock
price below market price. So, whether a stock is rising or falling in price, a strategy of following the
momentum (buy the winners and sell the losers) is justified due to the disposition effect.

Biological Basis for Errors in Risk Assessment 19


The OFII factor library offers a number of tools that evaluate momentumEarnings-to-Price Momentum,
Earnings Momentum, Internal-Growth Momentum, Long-Terms Earnings-Yield Momentum, Price
Momentum (over both a nine- and twelve-month horizon), Return-on-Equity Momentum, Revenue
Momentum, and Yield Momentum. Looking more closely at Price Momentum, as an example of OFIIs
momentum-measuring tools, our team is able to utilize this factor to measure relative strength or
weakness within one economic sector. The idea behind this factor is that a stocks prospects are not
completely defined by a companys balance sheet and income statement fundamentals. A stocks price
trend may capture important non-quantifiable or qualitative factors such as corporate restructuring,
management changes, pending patent or drug approvals, investors behavioral considerations, etc.
Currently, we run two versions of Price Momentum: one is based on a companys total return over the
prior twelve months (lagged one month because of the short-term price reversal phenomenon); the other
uses a slightly shorter, nine-month horizon.

Earlier, we focused on the recency effect: that given a list of things to remember, we are most likely to
recall the last few things rather than those at the beginning or middle of the list. From an investing
perspective, individuals are most likely to recall the most recent market returns. In bear markets, this often
drives investors to a lower-than-optimal allocation to equities. For a quantitative manager, stock selection
is model-driven, without the influence of human emotion. A quantitative manager will not act impulsively,
even under conditions such as we have been experiencing over much of 2008-2009. Instead, by
maintaining a full allocation to equities, each client will be in a position to benefit fully from a new bull leg.

Biological Basis for Errors in Risk Assessment 20


V. Conclusions

Ongoing research and new techniques continue to uncover the particular strengthsand weaknesses
of the human brain. Driven to make sense of their environments, humans appear well wired to make snap
judgments in potentially life-threatening situations. But our synaptic shortcuts may leave us less able to
deliberately assess the full array of information surrounding us; our biological programming may cause us
to miss the forest for the trees. Overconfidence, loss aversion, false perceptions, and the like may all
conspire to distort our judgment when it comes to long-term investment planning. In this brief paper, we
discussed some of the most common errors in judgment, their causes and effects, and how a quantitative
investment process may mitigate some of the more pernicious errors.

Humans look for patterns, rely on trends, even when it comes to investing. Quantitative managers rely
simply on the available raw fundamental data for each security in their investable universe. That data can
come from any number of sourcesincluding (but not limited to) Thomson/Baseline, Thomson/First Call,
Gradient/Lancer, Compustat, and FactSetand is used as inputs to proprietary investment processes.
Financial models attempt to account for valuation, growth, risk, and management quality. Generally
speaking, quantitative investment processes have less chance of falling victim to human errors in
judgment; they do not recognize trends such as the hot-hand, nor do they fall for the gamblers fallacy.
They do not allow a portfolio to continue to hold a security simply because it has fallen in value
(disposition effect). The negative effects of human emotion should have no place in a rigorous investment
process; quantitative processes offer a disciplined and dispassionate approach and an ability to control
risk levels that, in the long run, may be just what is needed for long-term success.

Internally, quant managers such as OFI Institutional employ teams of skilled research analysts to screen
data on a daily basis. Company data extracted from SEC filings, the ultimate source for outfits such as
Baseline and Compustat, are dependent on the quality of the companys internal procedures and audit
review. The OFI Institutional research team reviews not just the earnings estimates supplied by external
(and internal) stock analysts, but the method by which those estimates were calculated.

Is there a way to avoid human errors in risk assessment, or are we all destined to fall into cognitive traps?
We contend that it is imperative to think through investment decisions rather than simply reacting
perhaps over-reactingto perceived immediacies. The current economic crisis challenges us like no
other time in recent history: Investor reaction to dire news regarding corporate earnings, unemployment,
housing data, and so forth has come swiftly, and market volatility has been unprecedented, on the upside
as well as the down. A sound, controlled, long-term investment plan remains vital; asset allocation
continues to play a crucial role in overall performance for any plan sponsor. As part of that allocation
process, we believe a quantitative investment approach can eliminate much of the risk of emotional
reaction to current economic news. When investment decisions are based on a firms underlying
fundamentals rather than impulsiveness or crowd behavior, the potential for long-term stability and
success, we believe, is increased.


Biological Basis for Errors in Risk Assessment 21


Notes

1,3 Judgment under Uncertainty: Heuristics and Biases, Amos Tversky; Daniel Kahneman, Science, New Series, Vol. 185, No.
4157. (Sept. 27, 1974), pp. 1124-1131

2, 4 Biases in casino betting: The hot hand and the gamblers fallacy, James Sundali (Managerial Sciences, University of Nevada,
Reno), Rachel Croson (Operations and Information Management, Wharton School, U of Penn), Judgment and Decision Making, vol
1, no. 1, July 2006, pp. 1-12

5 Hersh Shefrin, Behavioral Finance: Biases, Mean-Variance Returns, and Risk Premiums, CFA Institute Conference Proceedings
Quarterly, June 2007, Vol. 24, No. 2:4-12, (doi 10.24698/cp.v24.n2.4700)

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Biological Basis for Errors in Risk Assessment 22


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Biological Basis for Errors in Risk Assessment 23


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