This article is part of our New Future series, a compilation of market insights and trends.
Managing risk is a priority for every treasurer, but the way in which they do this is changing. Markets continue to be volatile, not the least affected by events unfolding globally. New technologies and disruptive business models are having, and will continue to have, a fundamental impact on internal business strategy and external market trends. Acknowledging the ambiguities in the markets may be an important first step to help navigating in the current environment. Let’s start with an analysis of some basic human traits and explore their implications in risk management decisions.
The Science behind Overconfidence
Let’s start with one question: “How likely are you to outperform 90 per cent of your classmates in a stock-picking competition on the local stock market?” In a famous experiment by Brenner, Izhakian and Sade in 2011, every single student was asked this same question.
If people, as a collective, were unbiased, one should expect the average response to be 10 per cent, as it is a mathematical truth that only 10 per cent of the class could outperform 90 per cent. As it turns out, the average response was 34 per cent. That is, on average, people overestimate their ability more than three times larger than the reality.
The Consequences of Overconfidence
While overconfidence may have an evolutionary advantage to our species (such as better immune system, better grit and less chance of giving up easily), there are some research-proven disadvantages to risk managers. Here are two examples:
- Research suggests that there is a statistically significant, positive relationship between the frequency of trading and the degree of overconfidence. (See The Review of Financial Studies.)
- Overconfident managers are also more likely to make lower-quality acquisitions when their firm has abundant internal resources. (See Journal of Financial Economics.)
(Acknowledging) Unfamiliarity Reduces Overconfidence
In the same experiment, two different questions were also asked:
A. “How likely are you to outperform 90 per cent of your classmates in a stock-picking competition on a foreign stock market?”
B. “How likely are you to outperform 90 per cent of the entire school in a stock-picking competition on the local stock market?”
Compared to the original question, the average response drops in both these questions with 28 per cent in A and 30 per cent in B, albeit still way above levels which would suggest more self-understanding.
Question A suggests that in the face of a less familiar market, our overconfidence naturally reduces. This is consistent with the well-known phenomenon of “home country bias” where investors always tend to overweight their home country without sufficient diversification.
Question B is even more intriguing: overconfidence seems to naturally reduce whenever some level of ambiguity is introduced. The entire school may be a less familiar benchmark than your own classmates, but there is no logical reason to believe that the school benchmark would be any harder to beat other than the fact that it is more ambiguous.
Research suggests that there is a statistically significant, positive relationship between the frequency of trading and the degree of overconfidence
In other words, humans may be optimistic, but we are also discounters. We automatically discount our own confidence whenever we encounter any ambiguities, including those that do not have any logical effect on the unbiased estimate.
Implications for Corporate Decision-Making
Overconfidence (or more simply optimism) seems like a hard-wired trait in human nature. Within corporates, leaders who got promoted are hardly the ones who were pessimistic. In other words, there is a strong selection bias to promote those who have an optimistic outlook in life and who are more likely to be perceived as driven and charismatic. Therefore, there are reasons to believe corporate leaders are even more likely to be overconfident than the average university students.
As we have discussed, however, untempered personal optimism could lead to miscalculations and suboptimal decision-making, especially in the risk management space.
Therefore, the first step for risk managers is to be aware of their own and their peers’ overconfidence, and devise processes to help remind themselves of such. For example, an objective risk modelling which assumes equal probability of gains and losses can be a good reminder.
Also, managers should encourage a culture of challenging assumptions. Only when we start challenging our assumptions can we acknowledge the ambiguities inherent within. As demonstrated by the experiment above, our mental discounting could help offset and diminish to some extent our overconfidence.
Implications for Treasury Risk Management
In the treasury space, overconfidence can lead to systemic under-hedging of exposures. Exposures may be under-hedged (or simply unhedged altogether) when treasurers hold market convictions stemming from their own overconfidence. Managers should instil discipline so that hedging is done consistently over the long term with unproductive risks being transferred away.
Market ambiguities have also become a topic of interest lately. Tools that allow market ambiguities to be gauged could be developed to aid decision-making. For example, HSBC’s Emerging Market Risk Indicator (EMRI) combines various information sources into a simple, rule-based and transparent risk indicator which is helpful for managing the ever-changing risks of emerging market currencies in a quantifiable manner.
What should I make of the current 'low volatility, high ambiquity environment?
It is important not to confuse volatility with market ambiguity, as volatility is a tradable product and hence can be easily distorted by market forces. For example, a bullish market tends to attract more aggressive yield-seeking trades which involve selling volatility, hence artificially depressing volatility levels. Therefore, volatility should be seen more as an inverse indicator of market sentiment than a reliable indicator of market ambiguity.
Market ambiguity, on the other hand, reflects something less tangible, such as the uncertainty of the world’s events unfolding. This may include geopolitical risks and policy risks, both the known unknowns and unknown unknowns.
Therefore, low volatility should be interpreted as a sign conducive to hedging similar to ‘falling insurance premium’ rather than a reason for complacency.
Given the complexities of treasury risk management, the HSBC Thought Leadership has put together a dedicated team of experts to help corporates optimise their strategy.
Next month ...
Next month, we will explain how our psychological need to construct stories to make sense of the world could inadvertently affect how risk managers are being evaluated.
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