Whether you realize it or not, behavioural biases and influences can lead to ineffective committee meetings and outcomes. However, having an awareness of their impact can not only contribute to making better decisions, but also improve portfolio returns. A combination of good investments and good behaviour is the recipe to achieving optimal outcomes.

Behavioural pitfalls can take many forms, such as the implications of not fully appreciating the likelihood of an occurrence or having a tendency to emotionally anchor consideration of alternative options to the current state of play. This article discusses these and other common pitfalls.

Pitfalls

One common pitfall is our tendency to underestimate the likelihood of an occurrence. Our assessment is often too focused on possible outcomes, whereas focus should be on the most likely or probable outcome. Another pitfall is not taking advantage of learnings from our experiences when reviewing different options. Taking advantage of our experiences increases the odds of making better-informed future decisions.

Anchoring is a tool used by car salespeople, where sticker prices on cars in a lot are much higher than what the buyer ends up paying. The sticker price anchors negotiations for the salesperson, but makes the buyer feel like they got a good deal when paying less than sticker price. Anchoring is one bias that plagues most investment committees when undertaking an asset mix review. Potential changes are compared to the current mix, which can make it emotionally difficult to stray too far from this mix. Moreover, such an emotional attachment may not be in the best interest of meeting the strategic goals.

Decision fatigue is a pitfall that most of us experience, but may not realize. It comes about when the number of decisions made in a day leads to our resolve being depleted and we put off decisions, or worse make bad ones. One cause of the fatigue is low glucose levels, which affects our decision-making energy.

Four villains

Chip and Dan Heath refer to narrow framing, confirmation bias, short-term emotion and overconfidence as the “Four Villains” in their book “Decisive”¹. You have a decision to make, but narrow framing makes you miss options. Think of narrow framing as a spotlight shining on one area of a stage where everything else that could be important is in the dark and is therefore not being considered.

When analyzing different options confirmation bias leads you to gather self-serving information. When too much focus is on information that confirms your personal viewpoint, and less weight on information that goes against your view, it can lead to an under-appreciation of the risks associated with a decision.

When you make a choice, short-term emotion can lead you to make the wrong one. Short-term emotion is most problematic for difficult decisions, where our feelings can adversely affect the decision with our heart ruling our head.

In making your decision, you can be overconfident of the future outcome. Overconfidence is an unfortunate state of mind where you believe you know more than you do about how the future will unfold, which understates the uncertainty associated with decisions.

Managing behavioural biases

Behavioural pitfalls cannot always be avoided, but they can be managed.

Figure 1: Managing the pitfalls

When assessing choices, it is important to understand the likelihood of an occurrence and focus your efforts and energy on the probable outcomes. When retrieving a memory your brain “replays” the nerve pathways created when the memory was formed. Recalling information helps strengthen our memories, highlighting the importance to be prepared for meetings in order to benefit from experiences and past learnings.

Being aware that some biases exist goes a long way to limiting their influence. When it comes to other biases such as anchoring, it is important to be open to ways to reduce influences. For example, when undertaking your next asset mix review, disguising the different mixes can help manage the risk of an emotional attachment to the current mix.

To combat decision fatigue, the best option is to schedule meetings early to improve the odds of making effective decisions. If meetings late in the day cannot be avoided, then agenda items should be organized with the most important first, when energy levels are higher. Having snacks available to provide a recharge of energy levels will also improve decision-making.

Managing the four villains

The “WRAP” process can help tackle each of the four villains.

Figure 2: Managing the villains

Widening options can uncover ideas that you may not have thought of and helps to avoid narrow framing. The concept is to think of physically moving the spotlight away from the area previously focused on in order to uncover different ideas or options. For example, if your committee is struggling with a particular challenge, reach out to a peer in the industry to find out how they tackled a similar challenge as a way to widen your perspective.

One approach to take when faced with confirmation bias is to reality-test assumptions by having someone play a devil’s advocate role to create constructive challenges and discussion prior to finalizing the decision.

To manage short-term emotion consider putting some distance between reviewing options and making a decision. The “10/10/10” tool developed by business writer Suzy Welch provides an elegant way of requiring us to put some distance when assessing decisions. Imagining how we will feel 10 minutes, 10 months and 10 years from now can help alleviate the emotional impact, since the longer the timeframe, the less the impact from emotional influences.

For overconfidence, you should prepare to be wrong, no matter how confident you may be. Having an appreciation that there is a risk things may not go exactly as planned can create an important awareness when assessing options.

Making better decisions

Sitting on an investment committee is a role where many decisions are required. While you cannot control how investments will perform, you can manage how behavioural influences and biases can negatively affect decisions. By doing so, you will improve the odds of meeting your long-term goals.

[1] Heath, Chip., and Dan Heath. Decisive: How to Make Better Choices in Life and Work. New York: Crown Business, 2013.

So far calendar year 2022 has been a challenging period for investors. Both equities and fixed investments have delivered negative returns and there are no obvious signs of any immediate improvement in the outlook as we navigate rising interest rates and high inflation. Not the ideal scenario for the introduction of changes in the charitable spending requirements for registered charities announced in the 2022 federal budget and expected to come into effect in 2023. This article provides a recap of key considerations for charities and the implications for the long-term growth of investment portfolios to ensure continued support of charities’ missions and objectives.

New Spending Requirements

The 2022 federal budget proposed an increase in the minimum distribution requirement for registered charities with fiscal years beginning on or after January 1, 2023. The proposed changes were met with concerned feedback on the timing from the charitable community and as such the new requirements have yet to be passed. It is anticipated that the changes will be in the next Budget Implementation Act, which could be passed before the end of the year. The key points of the changes are:

• The minimum distribution quota (DQ) will increase from 3.5% annually to 5.0% for property above $1.0 million that is not used directly for charitable activities or administration
• The calculation is based on the average value of property exceeding $1 million during the prior 24 months
• Administration and management fees do not qualify for satisfying a charity’s DQ, which was a previous source of confusion
• The Canada Revenue Agency (CRA) can grant a reduction in a charity’s DQ in any given tax year
• The accumulation of property rule which exempts charities from including certain property in their DQ calculation will be removed
• If certain requirements are met, registered charities can make “qualifying disbursements” to non-qualified donees.

What are the Implications?

While charities and foundations have different missions and objectives, most have a common goal to operate in perpetuity by generating returns sufficient to grow their assets after accounting for spending distributions and other costs. The potential implications to such a goal will depend on the actual spending practices of charities. Some charities as a practice may already be distributing close to the 5% minimum, while for others this will signal an increase in their spending policy.

As discussed in a previous article, establishing a regular spending formula and adhering to it is appreciated by grant recipients who receive a consistent cash flow. However, the strategic asset mix of a charity’s investment portfolio and associated risk and return profile typically supports the spending target. Specifically, to support a spending target of 3.5% implies a different asset mix and associated risk and return profile compared to a higher 5% target.

For those charities where the new requirements will imply a higher distribution, there are two options in their toolkit to meet the higher target:

• Generate higher returns from invested assets; and
• Receive additional donor contributions

While a combination of the two options will be beneficial, generating higher returns from its investments can be more in a charity’s control.

Strategic Asset Mix

Notwithstanding calendar year 2022 is on track for negative returns, with both equities and fixed income declining year-to-date to the end of October, one positive outcome of the rapid rise in fixed income yields is the higher longer-term outlook for fixed income. This is because there is a strong relationship between the actual return investors earn and the current yield. For example, for the Canada Universe Bond Index, Figure 1 illustrates how the current yield provides an indication of the expected return for the next 10 years, as well as the direction of returns. The chart plots the universe bond yield over time (blue line), as well as the actual subsequent 10-year returns represented by the purple line.

Figure 1 – Universe Bond Yields versus Subsequent 10-Year Returns

With the rapid rise in yields, the longer-term outlook has vastly improved. The yield on the Universe Bond Index at the end of October had risen to 4.3%, suggesting the expected return over the next 10 years would be similar, although with the potential for further interest rate hikes, there could still be shorter-term periods of negative returns. Despite the shorter-term challenges, it suggests a portfolio of fixed income alongside an allocation to equities could be well positioned to achieve a 5% return.

However, for many charities the return goal also considers inflation to maintain the real value of the portfolio of assets. While inflation is currently elevated, for the purpose of illustrating the impact of inflation combined with higher distributions, and assuming an annualized inflation of 2.5% for the next 10 years, then the minimum real return goal would be 7.5%. It is less likely that a portfolio of fixed income and equities can achieve the higher 7.5% return, unless it is largely invested in equities, implying a risk and return profile that many charities would not be comfortable adopting.

One action item for committees would be to include an agenda item at a future meeting that considers potential alternative investments, such as private market investments including real estate, infrastructure, and private debt, and the extent to which these could improve the risk and return profile of the investment portfolio. It would also be appropriate to consider other higher yielding assets, including commercial mortgages, emerging market debt, as well as the potential role of hedge funds to contribute to the return and diversification role. However, a careful assessment of specific alternative investments would be needed to understand any implications from the higher interest rate environment on the longer-term outlook for these types of investments.

Understand Your Circumstances

During these turbulent times, it is important to maintain a long-term perspective for the charity’s investments. With the new spending requirements, it will be beneficial to review your own circumstances and goals to understand the ability to gather additional support for the charity through contributions compared to the requirement for higher investment returns. Make time at a future committee meeting in 2023 to review your long-term outlook and requirements.