Recent market events have shown that traditional economics and approaches to risk do not adequately describe real markets and their potential impact on financial portfolios, according to a study released Monday by BNY Mellon and Investor Analytics.

The study, titled “Tomorrow’s Risk Management: How behavioral economics, cognitive studies and complexity science add up to more than their own sum,” recommends that risk managers explicitly incorporate lessons about known human biases into market stress tests and scenarios.

In surveying the fields of behavioral economics, cognitive studies and complexity science, the report found that while humans are risk averse when it comes to gains, they are risk takers when it comes to losses. It also says that more credibility is given to scenarios that are rich in detail, even though these scenarios are statistically less probable to occur in real life. Also, the study says that rather than diminishing with improved efficiency, volatility is actually a necessary component for the existence of markets, and does not change with efficiency.

“With the breakdown of traditional risk management…in the run up to and during the financial crisis, these new fields offer a thought-provoking perspective,” said David Aldrich, head of alternative investment services EMEA at BNY Mellon, in a release. “We believe firmly that risk management will look very different going forward, and will provide enhanced analytics for practitioners to analyze risks within their portfolios.”

“This report highlights the critical need for managers, investors and risk professionals to take a fresh look at how they are determining risk in their portfolios by incorporating not just the fact that we are irrational decision makers, but actually incorporating the very ways in which we are irrational in making our decisions,” said Dr. Damian Handzy, chairman and CEO of Investor Analytics. “This is paramount if we are to improve our understanding of markets and their inherent risks.”

In June, BNY said it has formed a strategic alliance with Investor Analytics to provide enterprise-wide risk analysis and reporting for asset owners and managers.

BNY Mellon is the corporate brand of The Bank of New York Mellon Corp., with offices in New York and London. Investor Analytics LLC, based in Berkeley Heights, N.J., is a provider of risk management service to the investment management industry.

This article can also be found at SecuritiesIndustry.com.


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