Financial advice I – Bounds to rationality

Carsten Murawski

Brain, Mind and Markets Lab

The University of Melbourne

Semester 2, 2019
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Quiz 3

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Today’s lecture

1. What is finance for?

2. Rationality and rational choice
3. Bounds to rationality
4. The role of advice

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 6
Source: Financial Times, 16 August 2019
1. What is finance for?

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[VIDEO]

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What functionality would you like Fortuna to have?

1. Write down the 5 functions or features that would absolutely want Fortuna to
have
2. Compare your answer with those of your neighbours and discuss why the
functions you want are important to you
3. Class discussion

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A functional perspective of finance

Traditionally, finance has taken a functional perspective, focusing on the

Function
”functions” the financial of Financial
system providesMarkets

Figure 2.1 Flow of Funds Through the Financial System 12

References: Merton, R., A Functional Perspective of Financial Intermediation, Financial Management, 1995; Mishkin,F.S. and Eakins,S.G., FinancialMarkets&Institutions, 6th edition,Pearson, 2008.

Mishkin, F. S. & Eakins, S. G. (2008): Financial Markets & Institutions, 6th edition, Pearson 11
Functions of the financial system (Merton, 1995)

1. A financial system provides a payments system for the exchange of goods and services
2. A financial system provides a mechanism for the pooling of funds to undertake large-
scale indivisible enterprise
3. A financial system provides a way to transfer economic resources through time and
across geographic regions
4. A financial system provides a way to manage uncertainty and control risk
5. A financial system provides price information that helps coordinate decentralised
decision-making in various sectors of the economy
6. A financial system provides a way to deal with asymmetric information and incentive
problems when one party to a financial transaction has information that the other party
does not

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References: Merton, R., A Functional Perspective of Financial Intermediation, Financial Management, 1995
A outcome-oriented perspective

More recently, the focus is increasingly being placed on financial outcomes, in

particular, financial well-being

Which outcomes do you care about?

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References: Breitbach et al., FinFuture – The Future of Personal Finance in Australia, 2019
A outcome-oriented perspective

More recently, the focus is increasingly being placed on financial outcomes, in

particular, financial well-being

How do we achieve the

desired outcomes given
the decision options
available?

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References: Breitbach et al., FinFuture – The Future of Personal Finance in Australia, 2019; figure adopted from Comerton-Forde et al., 2018
The state of financial wellbeing in Australia

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References: Breitbach et al., FinFuture – The Future of Personal Finance in Australia, 2019
Most Australians have regrets when it comes to their finances

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References: Breitbach et al., FinFuture – The Future of Personal Finance in Australia, 2019
What is preventing people from improving their financial situation?

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References: Breitbach et al., FinFuture – The Future of Personal Finance in Australia, 2019
 19
Source: pursuit.unimelb.edu.au, 20 August 2019
The problem

Choice

Input Output

Household characteristics Decision rule

(e.g., expected Financial
External conditions wellbeing
Goals utility maximisation)

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The (traditional) ‘solution’

Input Output

Household characteristics Financial

External conditions wellbeing
Goals

The traditional model of financial services (and regulation) is ‘input-oriented’ and product-centric 21
2. Rationality and rational choice

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What does it mean to be rational (in economics)?

● Economists are concerned with characterizing the decision rules people use
(and sometimes they are also concerned with the rules people ought to use)
● It is typically assumed that those decision rules are “rational”
● “Rationality” and “rational choice” have very specific meanings in economics

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The most basic definition of rational choice

● In economic models, it is typically assumed that agents rank all acts (choice
options) available to them
● More precisely, it is typically assumed that a preference relation ⪯ over acts is
a total preorder, that is, it is both transitive and total
● Transitivity: For all acts f, g and h,
if f ⪯ g and g ⪯ h, then f ⪯ h
● Totality: For all f and g, we have either
f ⪯ g or g ⪯ f
● A preference relation that is both transitive
and total is called rational

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References: Savage, The Foundations of Statistics, 1954; Shafer, Statistical Science, 1986; Bossaerts, Yadav, Murawski, Proc Royal Soc B, 2018
Some back-of-the-envelope considerations

● Suppose a person is a given a choice between subsets of goods (e.g., items in a

supermarket) from a set of 10 available goods
● The number of subsets that can be formed is 1,024 (210)
● For the person to establish a total preorder over all possible subsets, they
would have to make 102,247,563 binary comparisons

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The average number of unique items in a typical Australian supermarket exceeds 20,000!
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Rational choice in the presence of uncertainty

● In the presence of uncertainty, additional assumptions are required

● It is typically assumed that agents can track beliefs about the occurrence of
future states, and utilities separately (Savage framework)
● The most famous model of rational choice in the presence of uncertainty is
(subjective) expected utility maximization: decision-makers are assumed to
choose from among available decision options as if they maximised SEU
● SEU is given by the utilities of outcomes in different states weighted with
subjective beliefs about the occurrence of those states
● Beliefs are captured by probabilities and new information is incorporated using
Bayes’ law

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References: Savage, The Foundations of Statistics, 1954; Shafer, Statistical Science, 1986; Bossaerts, Yadav, Murawski, Proc Royal Soc B, 2018
Risky decisions and risk preferences
Table 1. The Ten PairedHolt
Lottery-Choice
& Laury task Decisions with Low Payoffs

Option A Option B Expected

Payoff Difference

1/10 of $2.00, 9/10 of $1.60 1/10 of $3.85, 9/10 of $0.10 $1.17

2/10 of $2.00, 8/10 of $1.60 2/10 of $3.85, 8/10 of $0.10 $0.83
3/10 of $2.00, 7/10 of $1.60 3/10 of $3.85, 7/10 of $0.10 $0.50
4/10 of $2.00, 6/10 of $1.60 4/10 of $3.85, 6/10 of $0.10 $0.16
5/10 of $2.00, 5/10 of $1.60 5/10 of $3.85, 5/10 of $0.10 -$0.18
6/10 of $2.00, 4/10 of $1.60 6/10 of $3.85, 4/10 of $0.10 -$0.51
7/10 of $2.00, 3/10 of $1.60 7/10 of $3.85, 3/10 of $0.10 -$0.85
8/10 of $2.00, 2/10 of $1.60 8/10 of $3.85, 2/10 of $0.10 -$1.18
9/10 of $2.00, 1/10 of $1.60 9/10 of $3.85, 1/10 of $0.10 -$1.52
10/10 of $2.00, 0/10 of $1.60 10/10 of $3.85, 0/10 of $0.10 -$1.85

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References: Holt & Laurey, American Economic Review, 2002

lotteries were determined to make the risk neutral choice pattern (AAAA/BBBBBB) optimal for
constant relative risk aversion in the interval (-0.15, 0.15). The payoff numbers were also
 30
Source: www.australiansuper.com.au
3. Bounds to rationality

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Can we always be rational?

● In economics, it is typically assumed that choices are rational (in the sense
defined previously)
● Intuitively, this means that in a decision situation, the agent chooses the best
(‘most preferred’) option available to them – this is equivalent to solving an
optimization problem
● An important question is whether we can always assume that people can make
rational choices (behave optimally)
● What are some of the potential barriers to rationality?

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One potential barrier: computational complexity

● Computational complexity theory is concerned with the resource requirements

of different computational problems
● Computational resources include time (number of computational operations)
and memory
● Different computational problems have vastly different resource requirements

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Models of computation

● A model of computation is a formal description of a particular type of

computational process
● The most important model of computation is the (universal) Turing machine
(TM)
● Computable functions are those functions that a TM can solve

‘Turing’s “machines”. These

machines are humans who
calculate.’

Wittgenstein

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Computations and algorithms

● A computation is any type of logical operation that follows a well-defined

model understood and expressed as, for example, an algorithm
● An algorithm is any well-defined computational procedure (sequence of
computational steps) that takes a set of values as input and produces some set
of values as output
● An algorithm can also be viewed as a tool for solving a computational problem

● The input sequence is called an instance of the sorting problem 36

Limits to computation

● A yes-no problem is undecidable if no computational device (TM) exists to solve

it
● Turing: The halting problem is undecidable
● Implications:
There exists a problem that no Turing machine (and hence no computing
device) can solve. In fact, there exist many such problems.
● There exist inherent limits to computation

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Computability

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Source: Valiant, Probably Approximately Correct, 2013
Computability and rational choice

● Proposition [Velupillai, 2000]. The process of rational choice by an economic

agent is equivalent to the computing activity of a suitably programmed Turing
machine

● Every aspect of choice by a rational economic agent corresponds to an

implementable procedure by a Turing machine

● Theorem [Velupillai, 2000]. There is no effective procedure to generate

preference orderings [thus, the generation of preference orderings is not
computable]

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Computational complexity

● The theory of computability investigates which problems a Turing machine can

solve using unbounded space and time
● The related computational complexity theory investigates how much time and
space are needed to solve particular problem classes
● The computational complexity of an algorithm is its asymptotic worst-case of
a resource (time, space) as a function of the size of its input

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References: Currin et al., J R Soc Interface, 2017
Class P Downloaded from http://rsif.royalsoci

(a)
● A (decision) problem is in the complexity class P if all 2n
EXP—not feasible

instances of size n of this problem can be solved by an n2 P—feasible

NP

algorithm that takes at most knc computational steps

time (n)
n

(time), for some constants k and c

● Informally, this means that for a problem in complexity log (n)

class P with input size n, one may need to wait an problem size (n)

amount of time—in the worst case—that is polynomial

(b)

in n
● Problems in class P are often called tractable since they NPC

e
im

co-
can be solved efficiently, that is, with a reasonable

Pt

NP
me
CE
EX

e
tim

log ti
PA

tim
P tim
NP
PS

amount of resources
References: Currin et al., J R Soc Interface, 2017
e
Figure 1 Computational complexity. (a) The feasibility thesis asserts that there
is a fundamental qualitative difference between algorithms that run41 in poly-
nomial time (P time) (e.g. schoolbook multiplication), and algorithms that
run in exponential time (EXP time) (e.g. position evaluation in a generalized
game) [2,11–18]. As problem size increases P time algorithms can still feasibly
(efficiently) be executed on a physical computer, whereas EXP time algorithms
cannot. The feasibility thesis also asserts that NP algorithms cannot feasibly be
executed, but this is less clear as this assumes P = NP. (b) Complexity classes
are related through the subset relationship: log time # P time # NP #
Class NP Downloaded from http://rsif.royalsoci

(a)
● The complexity class NP contains problems whose 2n
EXP—not feasible

solutions can be efficiently verified n2 P—feasible

NP

● Many important computational problems are in class

time (n)
n

NP, including the travelling salesman problem (decision

version), the satisfiability problem, the set cover log (n)

problem and the 0-1 knapsack problem (decision problem size (n)

version)
(b)

● At present, it is an open question whether NP is a strict

superset of P, known as the P versus NP problem NPC

e
im

co-
● The hardest problems in class NP are called NP-

Pt

NP
me
CE
EX

e
tim

log ti
PA

tim
P tim
NP
PS

e
complete Figure 1 Computational complexity. (a) The feasibility thesis asserts that there
is a fundamental qualitative difference between algorithms that run42 in poly-
References: Currin et al., J R Soc Interface, 2017x nomial time (P time) (e.g. schoolbook multiplication), and algorithms that
run in exponential time (EXP time) (e.g. position evaluation in a generalized
game) [2,11–18]. As problem size increases P time algorithms can still feasibly
(efficiently) be executed on a physical computer, whereas EXP time algorithms
cannot. The feasibility thesis also asserts that NP algorithms cannot feasibly be
executed, but this is less clear as this assumes P = NP. (b) Complexity classes
are related through the subset relationship: log time # P time # NP #
 c⇤ = argmax V (c)
c
V (c) = EP [u(c, s)]
Example: rational grocery shopping
X
max v i xi
i
subject to
X
wi xi  C and xi 2 {0, 1}
i

Note: Estimated number of atoms in the Universe: between 1078 and 1082
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Another example: The traveling salesperson problem

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Solving the traveling salesperson problem

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Computational ‘free lunches’

Many (computational) models of cognition and behavior are (computationally)

intractable. They include:

● Expected utility maximisation (e.g., Bossaerts, Murawski & Yadav, 2018)

● Bayesian belief updating/learning (e.g., Cooper, 1990)
● Combinatorial optimisation problems (e.g., Meloso, Copic & Bossaerts, 2009;

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What about human computation? The Church-Turing thesis

● The (original) Church-Turing thesis states that a

function on the natural numbers is computable by a
human being following an algorithm, ignoring resource
limitations, if and only if it is computable by a Turing
machine
● The more modern version states that the set of
computable functions is no larger on any other
computational model than on the Turing machine
● A computer is anything that can implement algorithms
for computable functions

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Is the brain a computer?

● A Turing complete computer is one which can implement any computable

function if implemented properly
● It has been proven that neural networks (NN) with multiple layers or recurrent
connections are Turing complete
● Thus, if we assume it has the same or more capabilities than artificial NNs, the
brain can be considered a Turing complete computer running algorithms

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How do humans perform on computationally difficult problems?

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References: Meloso, Copic & Bossaerts, Science, 2009; Murawski & Bossaerts, Sci Rep, 2016
The 0-1 knapsack problems – Experimental evidence

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References: Meloso, Copic & Bossaerts, Science, 2009; Murawski & Bossaerts, Sci Rep, 2016
51
Human performance in the 0-1 knapsack problem

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References: Murawski & Bossaerts, Sci Rep, 2016
Can we ‘rescue’ rational choice?

● ‘As if’
● People approximate rational choice
● Most instances encountered in real life are ‘easy’ – open question [average-case
complexity]
● Most instances encountered in real life are ‘easy enough’ and we have evolved
heuristics to solve them (considered unlikely) [ecological rationality]
● The brain can ‘do things’ a TM cannot do (brain is ‘super-Turing’) – open
question (considered unlikely) [alternative models of computation, eg, quantum
computing]
● Decision-makers compute in interaction with the environment – open question
(plausible)
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Implications for regulation

● Much of regulation of consumer markets (e.g., in finance) has been based on a rational
actor model (‘rationalism’) – the individual consumer always knows what is best for them
● The corresponding concept in law is that of the “reasonable consumer”
● In this model, regulation ensures that the consumer always has the inputs available that
are necessary for the consumer to maximise EU (e.g., disclosure paradigm, proliferation
of choice, financial literacy education)
● Our work suggests that ‘sub-optimal’ outcomes may often be the result not of lack of
input but due to high computational complexity
● Some financial products are so complicated that their pricing problem is not even
computable (cf. e.g. Arora, Barak & Brunnermeier)
● Complexity, allegedly, has been used to increase profit margins (‘opaqueness’ of
contracts)
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Other impediments to improving financial wellbeing
Engagement
Current challenges:
• Lack of awareness
• Lack of (financial) literacy
• Lack of access to
information
• Lack of trust
• Lack of time
• Psychological factors
• Lack of data
• Lack of technology
Problem-solving
• Lack of knowledge
• Lack of capabilities
• Complexity of problems
• Lack of trust
• Lack of time
• Psychological factors
• Lack of data
• Lack of technology
• Lack of services/instruments
Implementation
• Psychological factors
(e.g., lack of persistence)
• Social factors (e.g., peer
pressure)
• (Frequent) change of
circumstances
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4. The role of advice

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What is the role of financial advice?

● As we have seen, there are a number of barriers to good financial decision-

making and thus to improving financial wellbeing
● The role of financial advice is to help people overcome those barriers
● Traditionally, financial advice has been delivered by people
● Increasingly, it is being delivered by machines (“robo-advisers”)
● In Australia, financial advisers (and the provision of financial advice) are highly
regulated

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The rise of robo-advice

● Robo-advisors have achieved significant success in recent years

● Top four robo-advisors in the US managed USD 128 billion in assets as of
November 2017 (an increase of USD 88 billion from 2015)
● Robo-advisors typically use their reduced fees to target millennials and low-
income households
● The average fee charged by a human financial advisor in 2017 ranged from 59
basis points (bps) (investment amount of USD 30,000,000) to 118 bps
(investment amount of USD 50,000), whereas robo-advisors can provide
services in reasonably lower amounts

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References: EY, The evolution of Robo-advisers and Advisor 2.0 model, 2018
 With the emergence of Robo-advisors in 2008, clients were able to get direct access to manage their accounts and have low barriers of
entry. Since then, traditional wealth management firms have begun leveraging their huge customer base and resources to provide more
digital services to clients. In 2010, Bank of America and Merrill Lynch launched Merrill Edge®, streamlining investing for clients. Australia
and New Zealand Banking Group Limited (ANZ) was an early adopter of AI technology with the use of IBM Watson to understand client
behavior. Blackrock acquired a digital advice platform in 2015 to enhance and inform on investment decisions. Financial institutions have
made significant investments in robotic process automation (RPA) technology to automate manual processes, underlying the need for cost
reduction and efficiency gains. Goldman Sachs, for example, is automating the initial public offering process6. In the wealth management

The rise of robo-advisers (cont’d)

sector. Charles Schwab and Vanguard have launched services that combine the human and automation aspect; other big corporations,
including Morgan Stanley, Merrill Lynch and LPL Financial also have Robos integrated with their human advisor aspect.

• Increase in analytics capabilities

• Interest in more affordable financial advice
• Decrease in trust toward human advisors after recession in 2008

The first Robo- Bank of America ANZ began using Blackrock acquired Major financial Betterment, an
advisor software developed a IBM Watson AI FutureAdvisor, institutions independent Robo-
was created hybrid guided technology to a digital device completed advisor, announced
investing model, explore trends in platform to significant that it will adopt a
Merrill Edge client behavior enhance its human investments in hybrid model that
financial advising RPA technology to allows clients to
offerings automate manual receive advice from
processes human financial
advisors7

2008 2010 2013 2014 2015 2016 2017

Emergence Accelerated adoption to technology Advisor 2.0

of first Robo- by human financial advisors
advisors

59
References: EY, The evolution
6 HughofSon,
Robo-advisers and Advisor
Jennifer Surane, “How2.0 to
model, 2018Wall Street’s Robot Revolution,” Bloomberg Business Week, 25 September 2017
Survive
7 Robo-adviser Betterment adds human advice, Reuters, January 2017

3 The evolution of Robo-advisors and Advisor 2.0 model

 Financial advisors have access to variety of tools
We see Advisor 2.0 as an evolution of delivering wealth management to investors. Technology and tools are changing the ways that human
financial advisors market themselves, interact with clients, optimize processes and develop and implement investment strategies. Firms will

Can we do without the human element?

continue to develop their channels to suit investors’ preferences, and these will coexist for the foreseeable future.

Enablers Functions Advice Client

channels segments
Robotic process automation

• Relationship management Millennials and

• Client reporting digital-savvy
• Data aggregation Big data and analytics clients who prefer
a fully automated
• Trend analysis Robo-advisor
solution
• Portfolio monitoring
Artificial intelligence (AI) • Campaign management

• Sentiment analysis Traditional Will the robots become

• Predictive analytics
• Chatbot
clients who more human or will
value consistent
Augmented reality (AR)/ Human support from humans become more
virtual reality (VR) financial human financial
robotic?
advisor advisors
• Incentive offering
Social media
• Data visualization
• Relationship management
• Outreach and brand Sophisticated
awareness digital clients who
favor occasional
conversations
Hybrid with human
Web/mobile-based tools
financial advisors
• Compliance
• Cost reduction
• Performance tracking
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References: EY, The evolution of Robo-advisers and Advisor 2.0 model, 2018

Robo-advice will likely continue as a channel, in

parallel with touch-heavy channels such as
‘Homework’

● What are the building blocks of a robo-adviser for investment advice? (e.g.,
inputs, logic/algorithms, output)

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Next week

● Lecture
○ Quiz 5
○ Providing advice
● Tutorials
○ Portfolio optimisation
● Mandatory readings:
○ James Pickford and Lucy Warwick-Ching, How AI will change the way you manage your money, Financial Times,
16 August 2019, https://www.ft.com/content/37ca12d8-b90a-11e9-8a88-aa6628ac896c
○ Refresher of basics of portfolio theory

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