Thorn bushes have roses

In the lead-up to the RBA’s interest rate decision this past week, interest rate ‘doves’ and ‘hawks’ opined the direction of rates. An interest rate ‘dove’ supports a move for lower interest rates. Conversely, a ‘hawk’ supports a move for higher rates. There is no doubt press coverage leaned more toward the hawks. Why? Because interest rate rises are bad for borrowers, equating to financial pain and we respond more to financial pain than we do financial gain.

We saw this during last Monday when the global share market fell by 3%. Over twelve months, to the end of the same day, the global share market is still up over 15%. The sky is not falling for long-term investors. You wouldn’t know it from the headlines.

With its headlines and short-termism, the media could impact our cognitive bias known as ‘loss aversion’. As humans, the loss felt from money, or any other valuable object, can feel worse than gaining that same thing.¹  Psychologists refer to this as Prospect Theory.

Prospect Theory or the human response to losses is stronger than to gains

Consider these two problems (This is summarised from Thinking, Fast and Slow²)

1 – You have been given $1,000
You are now asked to choose one of these options:
50% chance to win an additional $1,000 OR get an additional $500 for sure

Or

2 – You have been given $2,000
You are now asked to choose one of these options:
50% chance to lose $1,000 OR lose $500 for sure

The ‘sure’ outcome of each problem means walking away with $1,500.

When presented with option one, most people take the risk-averse option and accept the sure additional $500. However, when presented with problem two, they are more likely to gamble, even though the probability is high that they will lose $1,000, not $500.

What researchers discovered was that, when weighed against each other, losses loom larger than gains and humans will do all they can to avoid losses. In the above example, they are prepared to risk $1,000 in problem 2 to preserve the $2,000.

This is a principle of Prospect Theory. Investors must evaluate and assess company results and prospects, each with uncertain outcomes, all clouded by economic uncertainty and central bank and government policy responses.

The options investors face involves the risk of a loss and an opportunity for a gain. We generally do not like to accept the risk of losses. For example, Behartzi and Thaler³, pondered why individual investors avoid share market investing even though the real returns had been about 7% per year since 1926. They attempted to determine what ‘premium’ people would accept to consider this higher returning investment option, which could incur short-term periods of losses, as we have seen in the past week.

Behartzi and Thaler found individual investors were “unwilling to accept return variability”⁴

Interestingly the Behartzi and Thaler research also considered the investment considerations of ‘organisations’, to test if they too were loss averse. The organisations they considered were pension and endowment funds. They found that these organisations were also susceptible to loss aversion but were more likely to have significant exposure to growth assets given the long-term nature of their investment objectives.

Of course, back in 1995 when Behartzi and Thaler wrote their paper, many people were not yet exposed to long-term investing for pensions. The superannuation guarantee had only been introduced in Australia three years prior. And the Behartzi and Thaler paper was based on the US experience.

In Australia, since then, share ownership has increased. Australian investors, via their superannuation have become more comfortable with short-term volatility which is “the price of admission for share market investing”, Morgan Housel referred. A slight drop in an asset that Australian investors cannot redeem for another 10, 20 or 30 years is not considered significant over the potential gains experienced over the life of the investment

What Behatzi and Thaler’s paper, as well as Prospect Theory, fail to allow is different reference points and perspectives and the feelings of disappointment and regret. 

Importance of a reference point

To address perspective and the importance of a reference point Kahneman, in Thinking, Fast and Slow, uses the following example, summarised below. He uses the monikers, Anthony and Betty.⁵ 

Both are offered the opportunity for $2 million. Who wouldn’t want that? Well, that depends on your reference point.

Anthony currently has $1 million, and Betty has $4 million. Consider if they are offered the following choice between a gamble and a sure thing, like the prospect theory test above. The gamble would leave them both with either $1 million or $4 million. Doing nothing and accepting the sure thing is to walk away with the $2 million.

Anthony who currently has $1 million will double his wealth with the sure thing. This is attractive. Alternatively, he can gamble with equal chances to quadruple his wealth or gain nothing. For him, that is risky.

Betty, on the other hand, will almost certainly baulk at the certain $2 million outcome because that means she will lose half her wealth. Alternatively, she can gamble and either lose three-quarters of it or retain her $4 million.

You can see that Anthony and Betty are going to make different choices. Anthony will take the sure thing. Betty will gamble to preserve her wealth. The different starting points, make the ‘sure’ outcome good for Anthony and bad for Betty.

You’ll note that Betty, faced with a loss becomes a risk seeker, like in Prospect Theory noted above. People seek risk when all the options are bad. It sounds counterintuitive but it’s true, it might be because they fear that feeling of regret or loss.

That feeling of regret

As humans we feel and feelings of regret or disappointment we naturally try to avoid. When you are investing you are exposed to possible future regret and people consider this when they decide to transact on an investment. This can lead to a process that behavioural economists call ‘narrow framing’. Barberis, Huang and Thaler (2006)⁶found that narrow framing is an important feature of decision-making when the outcome could lead to regret. Narrow framing is the process of using information that is most accessible. This could be daily media headlines and short-term returns in the current market environment. They are the most accessible. Some funds won’t publish the returns experienced this month until the middle of next month.

The regret could also be missing out on gains. Perhaps a period of market weakness is a potential opportunity to buy an asset.

This is where information filtering is paramount.

It’s important to look past the positive and negative commentary and concentrate on your long-term goals. Rate rises, inflation and volatile markets naturally make investors anxious. These are potentially thorns, it's important to consider the whole stem, including the potential rose buds.

Successful long-term investors survive short-term falls by sticking to investment principles that have withstood the tests of time. For portfolios, this may include better diversification. For equities, investing in profitable companies with strong balance sheets and stable earnings has historically given resilience to portfolios. 

We also need to be aware of ourselves, our biases and our point of reference. We become better at assessing investment risks if we understand our inherent biases and thus better long-term investors.

Michael Burry, one of the subjects of Michael Lewis’s The Big Short, said “I certainly view volatility as my friend. Volatility is on sale because 99% of the institutions out there are doing their best to avoid it.” While we would not describe it as a friend, we see it as inevitable. Each investor must determine how comfortable they are with it. Understanding your aversion to losses, considering your starting point or how you will feel about a potential outcome can help you smell the roses and become a better investor.

Sources: 

¹Kahneman, D., & Tversky, A. (1977). Prospect Theory. An Analysis of Decision Making Under Risk, Econometrica. 47(2): 263-291

²Kahneman, D. (2011) Thinking, Fast and Slow, United States, Farrar, Straus and Giroux

³Benartzi, Shlomo; Thaler, Richard (1995). "Myopic loss aversion and the Equity Premium Puzzle". The Quarterly Journal of Economics. 110 (1): 453–458

⁴ibid.

⁵Kahneman, D. (2011) Thinking, Fast and Slow, United States, Farrar, Straus and Giroux

⁶Barberis, Nicholas; Heung, Ming; Thaler, Richard H. (2006). "Individual preferences, monetary gambles, and stock market participation: a case for narrow framing". American Economic Review. 96 (4): 1069–1090