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Bridging the Behavior Gap

March/April 2020

By Lisa Whittington

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To help their institutions make smart endowment investments, CBOs must watch out for cognitive biases, ask questions, and back up their decisions with data.

“Resilience: Creating the All-Weather Portfolio,” a Feb. 6 session at the NACUBO 2020 Endowment and Debt Management Forum in Washington, DC, began with good news: There were few challenges in assets for higher education endowments in 2019, and long-term returns exceeded many institutions’ target expectations. However, assumptions for future portfolio performance were much lower than what we have seen in the recent past, according to Katie Nixon, executive vice president and chief investment officer, wealth management business at Northern Trust.

It’s human nature to avoid risks in times of trouble, but Nixon warned that de-risking too readily can cause investors to miss out on the minor market upswings that are crucial for sustaining institutions’ longevity. Nixon called these missed opportunities the “behavior gap” in investment performance.

Behavioral Economics 101

“The future will have challenges—not in low returns but in how we react to noise from the market,” Nixon said. Here are five cognitive biases to watch out for in your institution’s investment committee:

  1. Herd mentality. Humans take comfort in groups and tend to jump on ideas that are perceived as good because others believe in them. For example, there’s been a lot of buzz around electric cars recently. There has been an upward trend of people buying shares in electric car manufacturers because it’s popular—everyone’s talking about it—regardless of whether the data is there to back up that investment.
  2. Confirmation bias. We see what we want to see, and ignore anything that might disprove our beliefs. For example, if you begin by assuming that a car manufacturer is doing well, then a lot of talk about that company may lead you to believe it is selling a lot of cars. But without evaluating all of the relevant data, such as how expensive the car is to make and whether the company’s growth is sustainable, you won’t see the full picture.
  3. Recency bias. We forecast what just happened into the future. A salient example of this is U.S. global dominance. As Americans, we think the U.S. will always be on top because it has been on top in recent years, and we ignore research that points to the cyclical nature of markets.
  4. Selective exposure. We tend to surround ourselves with people who have the same beliefs, biases, and backgrounds as us. If everyone on your institution’s  investment committee always has the same perspective, chances are they won’t have the whole picture—whether by missing out on smart investments or by taking uncompensated risks.
  5. Groupthink. Humans are social animals, and we tend to want to get along with everyone, especially if dissent is discouraged or punished by a group’s leaders. Combined with selective exposure, this leads to bad investments being made blindly without any dissenting opinions brought forth.

What Does the Data Say?

To avoid these biases, CBOs must be able to ask tough questions when they don’t believe something or know what it means. According to Kent Stanley, vice president for university advancement, Minnesota State University, Mankato, CBOs must make sure that committee decisions are supported by solid data; as he puts it, “That’s great, but what does the data say?”

Board culture is also critical to building a successful investment committee—look for talented individuals who don’t dominate the conversation or have conflicts of interest. “There’s a psychological difference between investing on behalf of an individual, which will sunset, versus an institution, which is expected to continue in perpetuity,” Stanley said.

It can help to have board members serve on the committee before they become chair. According to Stanley, board chairs who first served on the investment committee tend to know more about their endowments, and subsequently make better investment decisions.

Prepare, not Predict

Assets serve a purpose: to fund your institution’s mission and goals, Nixon said. What does risk mean to your investment committee? Ultimately, too much risk means CBOs won’t be able to meet their institution’s mission. Make sure that all risks your committee is taking at the portfolio level are compensated.

Your committee might believe “diversification” of assets can create a buffer against market drawdowns, but many people mistake having various types of equities in their portfolio for true diversity. “A real buffer zone is created with a balance between risky assets against cash and high-quality fixed income,” Nixon said.

While public equities and credit—the traditional 60/40 investment portfolio—drive the majority of returns, committees should balance those investments with illiquid assets—such as hedge funds, private equity, commodities, and real estate—to generate alpha, the rare residual return from investment manager skill after adjusting for other exposures. This balance may allow your institution to prepare for market changes, and it’s especially crucial in times of stress, though it can be hard to maintain. Kent and Nixon emphatically agree: Don’t de-risk after a deep drawdown because the market is cyclical and will go up again, even if you can’t predict exactly when.

Slow and Steady

One of the appealing aspects of many illiquid assets is that they cannot be easily sold without incurring substantial costs, which means your committee won’t be tempted to dump them in times of stress. Illiquid assets can be helpful for diversifying your portfolio, but Nixon cautioned against considering them as a fix-all, especially since fees and other costs can be very high. The illiquidity premium is still positive, but it is decreasing in value now that more investment management companies are starting to use these strategies.

LISA WHITTINGTON is associate editor, production, Business Officer.


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