Investing in a behavioral world Perspectives of performance measurement and risk

management through Investment Games

By Guillaume Holmberg-PérouxAmbassador HEC Lausanne – swissnex Singapore

Disclaimer : This presentation is my personal view and any mistakes are my own.

Looks familiar?

Financial Times, 29 June 2014

Investment Games : part I

“Financial markets are like a big casino”

You are here

Roulette-like betting on companies

If markets were random and rules didn’t change

Simulation of daily Geometric Brownian motion generated prices, variance=3%

If markets were random and rules didn’t change

Simulation of daily Brownian motion generated returns, variance=3%

Tools for this world

• CAPM, Market Beta (performance)• Normal Distributions (risk management)• Black Scholes Option pricing/hedging• Modern Portfolio Theory and efficient frontiers• Value at Risk

Focus on volatility, expected returns, correlation

=> tools of the 20th century

What happened

Old Financial Understanding

2007 Crisis

(Wild) Reality

Real daily returns of STI index since 1998 (Source: Yahoo Finance)

Sumatra Earthquake -2004

Seismograph - Source : thegeosphere.pbworks.com

(Almost) Newer tools

• GARCH models (risk management)• Regime switching / Jumps• Non-normal distributions modeling

=> Patches on the old models

What will happen?

(Almost) New Financial Understanding

Next Crisis

Practitioners’ tools

• Fama-French: Size (B/M), Value (P/E) Momentum

• Fundamental analysis (cash flows, comparables, ratios)

• Technical Analysis (head and shoulders, ..)

=> doesn’t tell the whole story

How bad was the misunderstanding?Measures?

Extracting aggregated expectations

Probability density function that matches aggregated stock market long term expectations and the correspondent risk profile (using monthly NYSE data, since 1963)

Pay attention to tails

Scaling of the distortion of probability on Nasdaq

New Insights

• Behavior and mismatch => shape risk profile and risk premiums, not the reverse

Problem: assumptions of the investment game itself, not just plain optimism

The right Investment game?

• Non (pure) randomness of human behavior• Chaotic (simple rules but complex results)• Non probabilistic (buy/sell/do nothing)

Non randomness of human networks

Preferential attachement : sharholding, credit networks, financial advice, .. => fat tails

Classic : the World wide web

Source : the Opte Project (2003)

Euro Area Banks Shareholding Network

Source : Peccora/Spelta 2014

Games on Financial networks : Investment Strategies (simplified)

• New restaurant that opens, with no reservation system, and it’s saturday night.

You go, but it’s crowded (costly) You go but some seats are free (Good? Bad?) You don’t go but some seats are free (Good? Bad?) You don’t go but it’s crowded (good)

Investment Game: Strategic complements and substitutes on information

• Characteristics :

- Herding vs Contrarian- Non-probabilistic views

+ (random) news

Models really well reality.

Similarities

Same fundamental mechanism across all markets at all ages

Non random but chaotic : good news

The system as a whole is partially predictable (long term memory and critical points)

Source : Sornette, 2013

Now what? The new tools for the 21st Century (work in progress)

• Multi-fractal models, Fractional BM, M Cascades• Agent Based Models, Dynamic Systems• Strategic formation, Behavior and Networks• DATA and technology

Volatility is not enough

Thank you, and happy investing!