Where behavioural finance and economics converge

Behavioural finance is a fascinating concept that has attracted growing interest over the last three decades. The basic conclusion is that we, as human beings, would be better investors but for the fact that we are, well, human!

Systematic managers often argue that, because their strategies are not subject to psychological and emotional constraints, they are able to follow a profitable trend long after a discretionary manager would have prematurely crystallised profits.

Conversely, discretionary managers typically counter with the argument that they can use their skills and anecdotal knowledge to predict a trend before it forms – something an algorithm cannot do.

For example, a contrarian portfolio manager might have taken a short position in sterling prior to the Brexit vote and captured significant profits, whereas an algorithm could only respond to the initial movement (which was a huge swing). But, by the same token, a systematic strategy will seldom, be drawn into allocating a substantial proportion of its risk budget on a scenario with such a binary outcome.

Consequently, most investment portfolios that include an allocation to a systematic strategy also invest with discretionary managers. There are merits to each approach and they often exhibit complementary return profiles.

Predictably irrational…

Of course, the knowledge that our behavioural tendencies expose our investment portfolios to ‘human risk’ is one thing, but how can we begin to address irrational irrationality? In this respect, behavioural finance took a huge step forward when Dan Ariely, an economist at MIT, published his 2008 tome ‘Predictably Irrational’.

The compass of Ariely’s research goes way beyond the world of investment – he conducted experiments covering many different aspects of social science in order to better understand exactly what makes humans tick and flip. In doing so he discovered that human beings do not calmly pursue our self-interests to the best of our ability, but are subject to occasional bouts of insanity. It is more the case that we are crazy individuals who are sometimes capable of being rational.

Ariely’s key finding, however, is that human beings are not randomly irrational, but predictably irrational. There is nothing that we can do to address random acts of behavioural weakness, but, if human risk can indeed be predicted, it must be possible to mitigate it. Of course, that is easier said than done and requires total honesty on the part of the individual.

Let’s face it, who would want to admit that their most profitable trade was, in fact, a reflection of good luck (being proved right for entirely different reasons to the investment thesis)? Similarly, it is far easier to suggest that losing positions stem from pure bad luck rather than an erroneous interpretation of stock fundamentals.

Take a step back to move forward…

While Ariely’s work has undoubtedly added a new layer to the science of behavioural finance, the seminal study in this field is Daniel Kahneman and Amos Tversky’s ‘Prospect Theory’ first published in 1979. The authors’ ground-breaking discovery is that human beings are risk averse when in profit, but risk-takers in deficit.

Although this sounds counter-intuitive, it simply has to be true and forms the very fragment of the theory of “Gamblers’ Ruin”. This, in turn, explains the enduring profitability of casinos and bookmakers.

It is eminently logical that any frequent gambler will experience winning and losing streaks, but it is the interpretation of how they will react to them that is key.

Since human beings are risk-averse when in profit, a gambler experiencing a winning streak will bet increasingly small amounts because they don’t want to lose their profits. Conversely, when on a losing streak, a human being is psychologically conditioned to become a risk-taker and the gambler is willing to invest increasingly larger amounts in a bid to break even.

The obvious outcome of humans being prone to these psychological tendencies is that gamblers typically squander much more money on a losing streak than they ever gain on a winning one.

A further key finding of the initial research of Kahneman and Tversky is that, in an investment context, our pleasure and pain receptors are not symmetrically aligned. That it is to say that the joy we feel when making any given level of profit is much smaller than the pain experienced when losing an identical sum. Moreover, as the level of profits or losses increase, our sensitivity to them diminishes.

These findings enabled the authors to scope out the ‘asymmetric value function’ which is the title illustration and has great explanatory power in terms of irrational decision making.

For example, we can look at the illustration and intuitively appreciate why investors typically cash in their winning positions prematurely. Moreover, it illustrates why a number of investors resolutely clung onto their Enron shares as the price plunged inexorably towards zero; once the share price had fallen by a certain percentage they were almost indifferent to further losses, while the gambler’s instinct would suggest that the most likely source of recouping their losses would be a recovery in Enron’s share price.

Rationally irrational…

The science of behavioural finance frequently uses emotive terms, such as biases, weaknesses and irrational decision making. Consequently, it may come as a surprise to many that the ‘asymmetric value function’ provides an immaculate illustration of a very well-known economic concept called ‘marginal utility theory’.

This purports that human beings seek to maximise the amount of satisfaction (measured in ‘utils’) for any given budget. For me, this is the absolute embodiment of sanity and I have never heard the theory described as irrational.

For example, let’s consider going out for a drink; since I like beer, we will suggest a satisfaction framework derived from drinking a few glasses of ice-cold lager.

The first one really hits the spot and slides down beautifully. Let’s say it cost ￡5 and I derived five utils of satisfaction from it, so I order another one. The second one still costs ￡5 and it tastes good, but I only gain four utils of satisfaction from it and the third one merely provides me with three utils.

By this point, I’m getting rather hungry, so I forsake a fourth glass of beer in favour of a hamburger and fries. This also costs me ￡5 but I derive five utils of satisfaction from the food, so it was a successful switch in terms of enhancing my satisfaction for the given budget.

To illustrate displeasure, let’s pretend that my income is right on the verge of a higher-rate tax threshold. If I earn any additional money, the extra will incur more tax than my basic salary. However, I am offered the opportunity to do some overtime…it’s a bit of a dilemma because I could really use the extra cash, but I don’t like the idea of even more of my hard-earned going into the exchequer’s coffers.

In the end, I decide to do four hours overtime this week. When I receive my payslip, I feel vexed because of the additional tax I have had to pay, but I spend the extra money on nice things like books and clothes…and that feels good.

The following week, I do six hours overtime and the one after that I do eight. I discover that I get progressively less uptight about the tax angle even though an increasing proportion of my total income is being taxed at the higher rate.

Active or passive?

I guess this is the interesting bit.

As investors are human beings, they naturally do not like to pay high fee loads. However, the concept of ‘buying momentum’ is completely contrary to the penchant of the human psyche for buying into weakness and selling into strength – we all love a bargain! And, of course, buying momentum is exactly what you are doing when you invest in any type of tracker fund where the underlying index is capitalisation weighted – the shares of any company that are outperforming the broader market become a progressively larger constituent of the index.

That’s fine when momentum is positive but completely disastrous when the bubble bursts. For example, the technology weighting of the S&P500 index increased from 14% to 35% in the five years preceding the bursting of the TMT bubble. And, of course, a passive fund will unwind its bubble positions much more slowly on the way down than a discretionary investor would. From this perspective, index-tracking is a popularised and accepted ‘buy high, sell low’ approach.

The other point is that humans do not like polarised outcomes. Although we are perfectly willing to buy lottery tickets, most would balk at making a sizeable ‘investment’ where the two outcomes are a 100% gain or a total loss. I have heard it said that investing in an index tracker eight years into a bull market is a bit like visiting a casino. But, it can’t be as clear cut as that because a stock market index is not going to fall to zero (I hope!).

However, a number of academic research studies have found that active managers are more effective in falling markets because it is easier to spot and avoid the biggest future losers (typically the stocks that have become a proportionately bigger component of the index in recent times) in a falling market, than it is to identify the potential outperformers during bull periods. Consequently, active managers should be able to cushion losses on behalf of their investors.

This is important because humans experience more pain from losing a given sum of money than the pleasure felt in gaining the same amount – this is clearly evident in Kahneman and Tversky’s illustration of the asymmetric value function.

Beyond the hedge of reason

Traditional active fund managers have come in for a lot of stick in the ‘commoditised’ equity environment we have been largely experiencing since 2009. Indeed, hedge fund managers have faced even greater criticism as investors have lost sight of the value of a proposition with lower participation on the upside in return for downside protection.

But, as the popularity of guaranteed equity bonds in the early 1990s clearly illustrates, humans are naturally drawn to a return profile with positive asymmetry. Moreover, there is nothing like a stock market crash to serve as a reminder of the benefits of downside insulation. Our affinity for ‘guarantees’ peaks when we least need them.

Who knows how much more life there is left in this bull market? But, one thing is for sure, it would be better for all if we could re-educate investors of the value of cushioning the downside before they have ample cause for appreciating it all by themselves.  

Please note these ramblings are entirely my own and I am not posting them in any official capacity. But, if you have enjoyed reading this, please 'like' and/or comment below