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What are the ideas that have fundamentally altered our thinking over the last 12 months?
Ex ante, it would be difficult and premature to say, but there have been writers and readers who have contributed to our understanding of facts, conceptual frameworks, and innovative ideas.
Indeed, many of the best articles of 2016 may have the legs to influence our thinking for years to come.
With that in mind, India and behavioral finance are a source of lively debate as well as subject areas that I have been reading, writing, and talking about with other professionals over the last year. There have been many stand-out pieces on these topics that are worth highlighting.
1. Behavioral Risk Profiling: A New Framework
Wealth advisory is among the most delicate and difficult of financial services. Not only do advisers have to deal with the impossible task of understanding future sources of returns and matching them with investor needs, but they must also overcome their own behavioral shortcomings and biases as well as those of their clients.
Understanding the influences that shape investor needs and decisions provides inputs to help advisers maximize the chances of achieving investor goals. “Risk Profiling through a Behavioral Lens” provides a detailed framework that advisers can employ to understand the decision-making biases that their clients might have.
2. Algorithmic vs. Independent Thinking: Investors Need Both
“We’re fundamentally over-confident in the sense that we jump to conclusions — and to complete, coherent stories — to create interpretations,” Daniel Kahneman said. “So we misunderstand situations, spontaneously and automatically. And that’s very difficult to control.”
Furthermore, Kahneman said, much of human error is not even attributable to a systematic cause, but to “noise”:
“When people think about error, we tend to think about biases. . . . But in fact, a lot of the errors that people make is simply noise, in the sense that it’s random, unpredictable, it cannot be explained.”
Kahneman’s advice for avoiding behavioral miss outs in critical decision-making areas? Replace human judgement, as much as possible, with algorithms.
The question is: Will artificial intelligence (AI) go beyond providing disciplined thinking inputs and also execute its own professional judgments?
Research studies suggest that a thinking AI could deliver such transformative change, though it may not happen anytime soon.
Disciplined thinking can be distilled and automated into algorithms. But the capacity for independent thought, for revising beliefs, is an area in which human beings singularly excel. Michael Mauboussin, Dan Callahan, CFA, and Darius Majd, discuss the hallmarks of successful fundamental investors.
The world’s largest hedge fund has a somewhat out-of-this-world, radically transparent company culture in which employees challenge each other and continuously share feedback — all to create a focus on independent thinking.
3. “The Trust Factory”
Trust is fundamental to everything we do. Whether reading, talking, eating, or shopping — every activity is guided by degrees of trust. Consequently, for financial services providers, nurturing trust is an existentially important activity.
Each of us has the ability to act in a trustworthy manner. But we have to watch out for and avoid behavior that can destroy trust. Dan Ariely has identified five important building blocks for trust: long-term relationships, transparency, intentionality, revenge, and aligned incentives.
4. Money: It’s Never about Numbers
That the narrative matters is a principle of the relatively well-defined world of valuation. The notion that money is not about numbers but about stories has an intuitive appeal. Our experiences and our sense of what others have experienced shape our decision making. Recognizing that every financial decision is influenced by a narrative can help advisers better understand their clients’ motivations.
5. Awareness and the Action Gap
Kahneman and Amos Tversky’s fundamental principle that our aversion to losses is greater than our appetite for gains is easier to understand than it is to integrate into practice. Potentially harmful, simple decision-making gaps are not limited to investments and exist despite heightened awareness. Understanding and being conscious of our persistent limitations, of the important role played by our unconscious selves, is for now perhaps the only tool we have to deal with these gaps.
6. Demonetization in India: A Difficult Miss
From the East to the West, the world over, this year has been a season of resets. But the government of India’s decision last month to ban 86% of the country’s currency, so far, may have caused the most pain for the end consumer.
Many consumer sectors in India have taken a direct hit. Financial markets, however, currently seem to be pricing in a “V” shaped recovery and are not anticipating a full-blown crisis. While the economic costs have thus far outweighed the benefits of weeding out money from the shadow economy, the surprise is that by-election results and surveys suggest overwhelming public support for the government’s initiative. The demonetization exercise also demonstrates the perils of misguided economic populism.
7. India’s Demography and GDP: Challenges Ahead
Poverty is a difficult problem for any country to overcome. This is especially true for India. The nation still has 300 million people who live below the poverty line.
Amitabh Kant, the CEO of NITI Aayog, India’s leading government policy think tank, has said that India would need an annual GDP growth rate of 10% to completely eradicate poverty by 2032. A jump of 3% from the current 7% growth rate is a tall ask in the current context of slowing global growth. In addition, with more than 40% of India’s population under 20 years of age, there will be increasing demand for jobs. What’s especially worrisome is that despite seemingly explosive GDP gains, India’s net job growth rate was only 3% between 2005 and 2012.
8. Rumblings at Tata Sons
The 148-year-old Tata Sons salt-to-steel conglomerate has had a good long run, but the unprecedented ouster of the group’s chairman has come as a negative shock for investors. Shareholders in Tata’s various companies so far have suffered losses of between 6% and 24%, with a market cap cost of about $10 billion.
So how can older companies and conglomerates adapt to survive? Increased competition has reduced the performance gap between the average and the best, and the longevity profiles of big companies are shrinking as firms struggle to maintain their competitive edge. There are no easy solutions: Companies have to work harder at creating customer and shareholder value — or be ready to be disrupted.
9. Goods and Services Tax (GST) Reform: A Longer Wait
Each of India’s 29 states and seven union territories has a different set of laws on sales taxes. Manufacturing goods in one part of the country and selling them in another is thus subject to a number of hurdles. The current regulatory structure contributes to delayed inventory and painfully slow interstate trucking and logistical movement as well as higher tax burdens. As constructed, the system imposes an estimated economic cost of about 20%–30%.
To create a unified national market, the Parliament of India passed the Goods and Services Tax (GST) in August. Expectations ran high in anticipation of the new framework following the passage of the GST, but the intricacies of creating one universal set of regulations, coupled with a lack of consensus among the government and opposition political parties, have made it unlikely that the April 2017 target date for implementation can be met. On the positive side, the government has demonstrated it is serious about structural reform, and investors should expect more initiatives over the next several years.
10. More Reform: The Advisory-for-a-Fee Model
The Securities and Exchange Board of India (SEBI), the country’s securities market regulator, has recently proposed reforms to move the country towards a fee-for-advice model in investment advisory services. The SEBI has recommended a three-year time frame for the transition. Prior to the latest proposal, the SEBI promoted a direct route for clients to invest in mutual funds.
The tentative regulation has been open for review and public comment. If it is passed, the changes to investment advisory services could transform India’s wealth management space, and set the stage for deeper penetration from robo-advisers and fintech. The scale is enormous: There are roughly 550 registered investment advisers in India and more than 50,000 distributors, some of whom also work as advisers. On the demand side, there more than 150,000 dollar millionaires.
The new regulations could create enormous opportunities for qualified advisers.
For more on investing in India, the 7th India Investment Conference: Searching for Alpha in a Divergent World, to be held on 13 January 2017 in Mumbai, will provide a unique opportunity for delegates to improve their understanding of key issues that will drive investment decision making.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: CFA Institute
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