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Wealth Management

TWO TO TANGO? MARKET DATA AND OPINIONS IN INVESTMENT MANAGEMENT

MARKET DATA

Sebastien Lleo is Associate Professor of Finance at NEOMA Business School (France)

 

Analyst views and expert opinions matter. They are an invaluable complement to market data when it comes to formulating relevant capital market expectations and to strengthening risk management models and practices. But watch out for behavioral biases!

“Garbage in – garbage out!” Every investment management professional has heard the warning that poorly formulated capital market expectations will get portfolio optimisers to produce inefficient, unrealistic, and even outright dangerous portfolios.

Thus, considerable efforts have taken place to turn available economic and market data into accurate capital market expectations. These lead to the development of slick statistical methods, effective econometric techniques, and powerful machine learning algorithms.

Opinions can also be an invaluable source of insights to construct accurate capital market expectations.

What are the types of opinions on financial markets?

Opinions take multiple forms in financial markets. They include analyst views, opinions from political and economic experts, super forecaster predictions, and investor polls.

Moreover, opinions abound on financial markets. Consultancy Quinlan & Associates reported that the bigger banks and brokerages emailed over 40,000 pieces of research every week in 2016, despite continuing job cuts in the financial sector. Social media also contribute to the spread of opinions: according to the financial website Modestmoney.com, there are at least 839 active financial blogs published in English.

Why should I use expert opinions?

Opinions have three key benefits.

First, opinions can be a crucial complement to traditional economic, corporate and financial market data to construct realistic capital market expectation, and keep those up-to-date. This statement is especially true in times of heightened uncertainty, such as market bubbles and financial crises, when traditional data fail to provide an accurate assessment of market conditions.

Second, opinions can strengthen risk management models and practices. Opinions can widen the range of scenarios considered in portfolio optimisation and risk management. Dissenting opinions provide a cornerstone for the construction of meaningful stress test scenarios.

Third, we can use opinions, even when traditional data are not. For example, assessors evaluate insurance claims, and appraisers estimate the value of illiquid assets, such as real estate and collectables, periodically.

How easy is it to collect opinions?

The inclusion of opinions requires extreme care.

Let’s look at analyst views and expert opinions. We all know that not all experts or forecasters are equally accurate. A widely reported study by CXO Advisory Group LLC tracked 6,582 forecasts for the U.S. stock market published by 68 experts between 2005 and 2012. The study found that average accuracy across experts was 47.4%, with individual accuracies ranging from a low of 21% to a high of 68%.

Therefore, investment management teams need to implement a process to guarantee the relevance of the opinions used in their models. This process, known as “elicitation,” is described in abundant literature. The books by O’Haghan (2006) and by Meyer and Booker (2001) are an excellent place to start. Essentially, the elicitation process helps to construct views that are specific, explicit, and structured. Opinions need to focus on a specific variable or parameter, such as the price of a given asset or the mean of a distribution. Opinions need to explicitly provide a mid-point or most-likely scenario, a confidence interval, and to relate the confidence interval to a probability distribution. Finally, opinions need to be structured to provide a transparent and auditable trail.

What are the implementation challenges?

Three main implementation challenges need addressing.

The first and most dangerous challenge is that opinions are often subject to the behavioral biases. Behavioral biases, in particular overconfidence, excessive optimism, conservatism, confirmation bias, and groupthink play an essential role in how finance professionals perceive and process information, and on how they form their forecasts. Recently, in a simulation study, Davis and Lleo (2020) recently found that the presence of biases explained nearly 70% of excess risk-taking. Therefore, it is crucial to debias forecasts before using them in any model.

Second, expert opinion models are Bayesian and therefore require the specification of a prior distribution. We can overcome this difficulty with some original thinking, as with Black and Litterman’ reverse optimisation exemplifies.

Third, aggregating of multiple expert opinions is considered an essential conceptual and computational problem because it requires engineering a joint distribution out of a collection of univariate distributions.

 

How can I integrate opinions in my portfolio selection model?

Currently, several families of portfolio selection models use opinions as input. The best-known and oldest is the Black and Litterman (1992) model, which uses analyst views to generate capital market expectations in a Markowitz-style single-period optimisation framework. This approach has been extensively discussed and developed in a large number of subsequent papers and chapters.

However, the Black-Litterman approach has two fundamental limitations. First, it is static, meaning that it locks portfolio managers into a “buy-and-hold” strategy, ignoring the possibility that portfolio managers may shift their asset allocation as financial market conditions change. Second, it ignores the presence of behavioral biases in expert opinions.

To address the first limitation, Frey et al. (2012) and Davis and Lleo (2013,2020) proposed two closely-related dynamic portfolio management models. Although both models are developed in continuous time, we can transpose them to a multiperiod discrete-time setting.

The second limitation has proved more elusive. At the moment, Davis and Lleo (2020) is the only dynamic portfolio selection model that addresses for behavioral biases.

 

References

Black, F., Litterman, R., 1992. Global portfolio optimisation. Financial Analyst Journal 48 (5), 28–43. Davis, M., Lleo, S., 2013. Black-Litterman in continuous time: the case for filtering. Quantitative Finance Letters. 1 (1), 30–35.

Davis, M., Lleo, S., 2020, Debiased expert forecasts in continuous-time asset allocation. Journal of Banking and Finance. 113.

Frey, R., Gabih, A., Wunderlich, R., 2012. Portfolio optimisation under partial information with expert opinions. International Journal of Theoretical and Applied Finance 15 (1). O’Hagan, A., 2006. Uncertain Judgments: Eliciting Expert’s Probabilities. Wiley.

Meyer, M., Booker, J., 2001. Eliciting and analysing expert judgment: a practical guide. ASA-SIAM Series on Statistics and Applied Probability. Society for Industrial and Applied Mathematics.

Wealth Management

HOW RESILIENT IS YOUR ORGANISATION’S SECURITY?

Kimon Nicolaides, Digital Services Group Head at MASS

 

Organisational security can be thought of like peeling the layers of an onion – with critical assets sitting in the middle protected by multiple layers, and if one layer is removed or breached, there’s another one underneath. At least that’s the way it should be – too often, however, we see a siloed approach to the different areas of security. In practice, physical, cyber and personnel security can be much more inter-related than many imagine.

The finance sector is arguably one of the more mature in terms of established security measures. However, it’s also vastly diverse, targeted by some of the most advanced threat actors, and one where even the smallest breach has the potential for significant impact, monetarily, or on market reputation, perception or confidence. Security measures should therefore be viewed holistically, led and understood by senior management, otherwise gaps for exploitation will be found by intelligent and experienced people, supported by an ever-growing arsenal of exploitation technology.

Here, we take a closer look at some of the things that comprise a holistic view of security – based on the approach we take with public sector and defence organisations.

 

Physical security

It may seem obvious, but the first layer to assess should be the physical access to your business. For all organisations, this step remains as true today as it ever has been – even for the finance industry where physical security principles have been established over many years.

This stage should go back to the basics of how an intruder could gain access, starting by reviewing the ‘perimeter’ controls. In fact, the first question is, ‘what is the perimeter?’. With the potential for distributed site facilities, linked remote assets, and supply chain dependencies, this simple question needs careful consideration.

Scenario-based analysis, using threat actor personas, motivations and objectives can really help by defining a where a ‘perimeter’ really lies. It’s also an invaluable methodology for exposing how an organisation could be exploited.

This stage should involve a review of physical controls such as fencing, access technology, CCTV coverage etc., including, their role in deterrence and detection of hostile reconnaissance activities.  Disrupting the planning cycle of attacks is often overlooked relative to direct prevention of unauthorised access.

Ultimately, security measures are only as effective as the people that apply them, so an understanding of human behaviours is essential. It’s important to consider how people’s actions affect overall site security and, why these actions occur.

Issues can range from the wearing of security badges in the street through to poor motivation and effectiveness of roving security staff or those monitoring CCTV. Simple and innocent human mistakes could form the seed of future security breaches.

 

Cyber security

The finance sector has progressed its cyber resilience considerably as it’s been dealing with threats for many years. But business sizes now range from the very large to the small and, as new forms of financial transactions evolve, protection becomes more challenging. There is an increased availability of cyber exploitation toolsets and associated managed services and coupled with a reduction in their cost – lowering the financial and technical barriers to advanced cyber-attacks.

This means that cyber security, even for the finance sector, needs to be taken to a new level and existing assumptions continuously challenged.

For example, while penetration testing regimes remain a vital tool in mitigating network cyber risk (including ‘CBEST’ which has been widely rolled out across the finance sector), these still remain a snapshot in time. While they deliver valuable depth of analysis within a network, they are often constrained in breadth of scope and can potentially leave vulnerability blind spots. Very frequent, lighter-touch cyber assessments can fill this gap as they offer a more dynamic view of ongoing vulnerabilities over a wider proportion of the estate, which could represent ‘low hanging fruit’ for the cyber actor. Assessments can be enhanced by applying modern threat intelligence techniques to rapidly identify existing compromises and potential weaknesses (including personnel and corporate digital footprint). This establishes a picture of cyber posture and vulnerabilities before any testing taking place.

Similarly, end-user device security is often viewed in terms of the encryption strength, keys etc.  However, modern methods of fault injection attack (a device’s response to artificially applied ‘fault conditions’ used to derive security credentials), can effectively sidestep assumed security measures, which would normally take decades to ‘crack’ using computer power. So, it makes sense to test a device’s vulnerability to fault injection, rather than assuming encryption alone will protect it.

For this reason, it’s crucial to examine the wider supply chain. In the finance sector, there is high dependence on suppliers of digital telecommunications and energy services, and when different systems are interconnected its challenging to pinpoint cyber resilience risks. Despite this, it’s possible to map complex information to establish risk, by identifying ‘hot-spot’ concentrations of dependencies that represent single-point failures within the complexity of the overall business operation.

 

The insider threat

The potential threat from insiders – those who might misuse their legitimate access to an organisation’s assets for unauthorised purposes – is often overlooked.

This is particularly true for financial businesses, where personal financial gain could be an incentive, or where security controls are so effective that hostile actors must exploit those with legitimate access to circumvent them. You can think of insider threat as the ‘grand master skeleton key’ of security, as there are few security measures that cannot be overcome by the right insider, or team of insiders.  Security compromises involving insiders can also have a disproportionately high business impact.

Yet many organisations consider insider risk to be mitigated simply by pre-employment screening and fail to recognise the spectrum of risks ranging from genuine human error, through to orchestrated insider activity by paid professionals. Insider cases frequently involve individuals who have been with an organisation for some years and have had some personal vulnerability exploited or exposed, or simply become disgruntled.

It’s a broad area to address. Internal governance, security culture, employee wellbeing, employment measures, corporate digital footprint, and perceived employee sentiment are some of the aspects that should be considered. When you have understood this for your own organisation, you should make the same assessment of your supply chain.

If the business is committed, it’s possible to use structured analytical methods to quantify your organisation’s maturity and assess where the key vulnerabilities and risks could lie. This understanding paves the way for improvement, and even small changes can make a big difference.

 

The hidden layers

Like an onion, there are hidden layers to security that may be overlooked so it’s important to consider physical, cyber and personnel security collectively, and to understand the dependencies you have as a business.

For example, your own environment may be protected, but if data is shared with your suppliers or partners, is it still secure? Similarly, if a supplier or partner has a security breach, what does it mean for your operation, your business continuity and your customers?

When assessing security measures, it’s essential to go an extra layer deeper and consider how a range of factors could impact your organisation and its readiness to respond to an incident.

At MASS, our security experts consist of professionals with extensive experience in preventing security breaches and performing assessments in accordance with Ministry of Defence processes, so that we can ensure our security analysis meets and exceeds industry best practice.

For more information, please visit: https://www.mass.co.uk/what-we-do/cyber-security/cyber-security-training/

 

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Wealth Management

HOW TO CATCH UP ON YOUR RETIREMENT SAVINGS

By Gerard Visser, Certified Financial Planner at Alexander Forbes

For many South Africans who were already finding it difficult to save for retirement, Covid-19 has created additional financial pressures which may take years to overcome.

If you stopped contributions to your retirement annuity, or took a payment holiday on your pension or provident fund, you might be worried about the shortfall created, and how you’re going to catch up.

Stop worrying and take action to avoid retiring with insufficient funds. There are many ways to contribute to your retirement, from employer and employee contributions to pension or provident fund, monthly contributions to a Retirement Annuity or a tax free savings account.

With many people having a reduced income due to the economic ramifications of Covid-19, it might be impossible to contribute a large monthly amount to catch up while having concerns such as debt to pay, but I recommend starting with your budget. This will aid you not only by freeing up extra funds to catch up your retirement contributions with, but could also create some peace of mind with an opportunity to pay debts off faster or save some discretionary money.

Gerard Visser

There are many reasons why it is important to follow a monthly budget. Besides reducing stress levels by keeping an eye on your spending habits, it also allows you to track your debts, finding opportunities to top up emergency funds or save extra towards your retirement. A budget goes hand-in-hand with setting and achieving financial goals.

A budget does create an additional administrative burden and requires time to update. I have my budget on an Excel spreadsheet and update it monthly when making EFT payments.

Costs for entertainment, groceries and petrol are variable in nature and change each month. You might end up not using all the funds set aside for these variable costs. Adding these leftover funds at the end of the month to your savings is a good habit to inculcate. The immediate impact might seem small but over time will make a positive outcome to both your retirement and the development of a savings mind-set.

When you are able to free up some money each month, start automating your savings. Instead of having a variable amount go towards savings, set up an automatic contribution, where you “pay yourself first”. Set up an automatic debit for your retirement savings and you’ll grow these funds without having to think about it.

One of the most important decisions you can take to help make your retirement comfortable is preserving your retirement funds when changing employer.

When starting new employment or if you are coming out of a payment holiday, try matching your employer’s monthly contribution toward your pension or provident fund, or if on a total cost to company structure, start on the maximum employee contribution percentage. By doing this as well as automating your savings, you get use to contributing those amounts and could potentially have a larger nest egg at retirement.

Remember that life happens, and your budget might come under strain – many of us have experienced this during the pandemic. If you have been going through a difficult financial time, it is time to reassess and ask yourself, what in your budget is necessary and what is actually a luxury?

It is never too late to start sorting out your finances, but the earlier you start, the better, and more achievable, the outcome will be.

 

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