The Power of Diverse Interests: Innovating with Behavioural Economics in Finance

Many of you are familiar with my enthusiasm for data and structured products, but over a decade ago, I embarked this unique journey working on a derivatives desk that proved to be both transformative and enlightening.

After transitioning into the realm of Behavioral Economics and its impact on the modern economy, I began exploring how this knowledge could be applied to structured products. In this pursuit, two intriguing theories stood out: the Bucket Theory and concepts such as Reference Dependence and Loss Aversion.

What is the Bucket Theory?

The Bucket Theory, often discussed in financial planning, proposes a strategy of dividing one's assets into different "buckets" based on time horizon and risk tolerance. By categorizing investments into short-term and long-term buckets, investors can better manage their financial goals and emotional reactions to market fluctuations.

What is Reference Dependence in Behavioral Economics?

Reference Dependence is a principle within behavioral economics that suggests people evaluate outcomes based on a reference point (e.g., the initial investment) rather than in absolute terms. This tendency significantly influences decision-making, especially in financial contexts.

What is Loss Aversion in Behavioural Economics?

Loss Aversion refers to the psychological tendency where individuals prefer avoiding losses over acquiring equivalent gains. This phenomenon can lead to risk-averse behaviour, particularly when faced with short-term investment decisions.

Applying different knowledge

Utilizing insights from these behavioural theories, our team critically assessed the landscape of structured products available in the market. Notably, we observed a predominant focus on long-term investments, which presented an opportunity to innovate and diversify our offerings.

Recognizing that most investors possess a short-term investment mindset and harbour strong loss aversion tendencies, we devised a strategy to introduce a new short-term structured product with capital protection features. This novel product not only broadened our portfolio but also appealed to a new segment of investors previously hesitant to engage with structured products due to risk concerns.

Our innovative approach involved creating mirror products with identical underlying assets and terms but differing in their directional bets on market movement. One product predicted the underlying asset to decrease from its initial level, while the other anticipated an increase. The coupon was a digital coupon.

What were the results of this strategy?

The outcomes surpassed our expectations. We experienced a remarkable 20% increase in market share and successfully attracted a new cohort of investors to the world of structured products. Additionally, the mirrored design of these products allowed us to optimize coupon rates by mitigating the need to hedge all optional risks. This efficiency enhancement translated into more competitive offerings and greater value for our clients.

In summary, embracing a multifaceted approach by integrating insights from diverse disciplines such as finance, behavioural economics, and product innovation not only broadened our horizons but also led to tangible success in expanding market reach and enhancing product value.