The joy and pain of investing

A large gap exists between the way people are supposed to make economic decisions and the way we actually make them. This gap is explained by a new academic discipline known as behavioural finance. Human nature, it seems, prefers some investment choices over others for reasons that have nothing to do with risk or return.

“I don’t mind taking some risks,” said Philip to his investment adviser, “but I don’t want to lose any money.” Traditional economic models simply could not explain that statement. How can he claim to be prepared to take risks, yet be unwilling to lose? The adviser, though, immediately understood that zero – the dividing line between gains and losses – holds a very special meaning for most people. Although the figures on either side of the divide are numerically identical, we do not perceive them as such.

This is one of the key observations of behavioural finance, a new field of research that exploits the past sixty years of research in psychology to enrich our understanding of consumers, savers and investors. One of the discipline’s most famous publications, a 1979 paper by two psychologists, Kahneman and Tversky, described the asymmetric nature of human perception when we evaluate potential monetary outcomes. Roughly speaking, we perceive the prospect of a loss with twice the intensity of that of a gain having the same monetary value. This means the loss of €100 brings us twice as much pain as the gain of €100 brings us joy.

Asymmetric perception of gains ans losses 

A further finding of their paper, entitled Prospect Theory, concerned the way people evaluate probabilities. There is a tendency for us to attach varying importance to a percentage point of probability depending on where it appears along the spectrum between ‘impossibility’ and ‘certainty’. We have, for example, a disproportional preference for sure outcomes relative to those that are merely probable.

As a consequence, people will typically pay more for one percentage point of probability if it moves the likelihood of an outcome from 99% to 100%, than they would to move it from 98% to 99%. We also have a tendency to view very low probabilities as being more likely than they really are. If that low probability outcome is positive, like scooping next weekend’s lottery jackpot, we will have a tendency to perceive our chance of winning as much greater than it really is, and to overpay for the opportunity to participate in it. If that low probability prospect happens to be negative, like being killed in a plane crash, we will have an exaggerated fear of it and overpay for insurance.

Systematic behaviour

The human tendencies revealed in behavioural finance research are systematic in nature. This means most people behave in the same way, at the same time, in response to the same stimulus. If our behaviour was random or idiosyncratic, it would not matter because the biased preference of one person would likely cancel out the opposing bias of another. That is what is meant by the expression ‘the wisdom of crowds’: the uncanny ability of a large number of competitors to correctly estimate an unknown value.

Polymath Francis Galton most famously observed the wisdom of crowds at the Plymouth Fair over a century ago when visitors were collectively able to accurately guess the weight of an ox. As there was no systematic element to the guesses, the high estimates cancelled out the low estimates such that the average centred on the correct weight. In the same way, if one asked a large number of people to choose a number between 1 and 9, the average would centre on 5. If for some strange reason, however, many people simply prefer the number 8, the average would be greater than 5. And it would not matter how many additional people submitted a number, the average would always be greater than 5.

Thus, when a bias is systematic, it does not disappear through aggregation: the bias that is evident at the individual level will also be evident at the group level. As investors’ behaviour is systematic, they will tend to do the same thing, or ‘herd’, even though they have no knowledge of each other’s decisions.

Loss aversion

If one combines Prospect Theory’s two main propositions – the asymmetric perception of gains and losses, and the unequal weighting of probabilities – many elements of investor behaviour become more understandable. For instance, it becomes clear why investors pay so much for protection against a stock market crash. A sudden, huge slide in equity prices is an example of a low probability event, hence investors are prone to perceive it as more likely than it really is, and portfolio insurance protects them from a loss they would disproportionally dislike. The portfolio insurance might be achieved by permanently holding highly rated bonds, capitalguarantee products, far-out-of-the-money put options, or by simply not holding any risky assets at all.

However, all of these strategies have been shown to diminish long-run investment returns. Prospect Theory also explains the appeal of securities like initial public offerings (IPOs). Such offerings are typically concentrated among relatively new firms in emerging industries. As a result, there is an elevated chance that many do not achieve their lofty ambitions, or even fail outright. A rare few, however, do perform exceptionally well. So, there is a lottery-like element to IPOs. If investors overrate the tiny probability an IPO will be the next Google, they will tend to overpay for the opportunity to participate in it. As a consequence, one would expect the long-run returns from IPO investing to be disappointing and, indeed, this is precisely what the research shows.

Loss aversion and probability weighting are but two of behavioural finance’s key revelations; there are many more. We human beings might never be able to correct all of our shortcomings as investors – it is part of our nature, after all. But we might, at least, stop being surprised when odd things happen in financial markets.

BANQUE DE LUXEMBOURG’S POINT OF VIEW