The stock market has been tumbling lately with S&P 500 Price Index declining by 11.76% from its peak on October 5th till the date of this post, and the dramatic media headlines are roiling investor sentiment far and wide e.g. CNBC reported:
The stock market is on pace for its worst December since the Great Depression.”
An uneasy “fear” threatens to overwhelm human minds during this holiday season. To be fair, the market looks pretty grim and the latest market rout could roll on… or not. But before we get down the stream of feeling to thinking, similar to when we start to feel sick, and eventually believe we are sick; we need to realize that in the world of investing, emotions can cause investors to make sub-optimal decisions. Even the greatest investment strategy can prove to be worthless if a portfolio manager lacks the discipline and emotional fortitude to stay put. Alpha Architect noted that Even God Would Get Fired, who having clairvoyance and the crystal ball knew exactly which stocks were going to be long-term winners and long-term losers, would likely get fired many times by the investors during market volatility and severe drawdowns. This is due to investor’s Psychological Myopia, a tendency to think short-sightedly, that leads to terrible timing by assessing relative performance over short horizons. Because we, as human beings, often ignore pieces of information in decision-making processes, it makes us think short-sightedly.
Before behavioral finance came into being, economist Paul Samuelson, offered a bet to a colleague by flipping a coin where the win was $200 if heads comes up or lose $100 if tails comes up. His colleague reportedly turned the bet down because he said, ” I won’t bet because I would feel the $100 loss more than the $200 gain“. This is called loss aversion bias, the degree of which could be different from one investor to another. For example, an investor without loss-aversion bias who would put a 50-50 probability of heads or tails from flipping a coin, his loss-aversion utility function is positive e.g. $50 [0.50($200)+0.50(-$100)] whereas an investor like Paul Samuelson’s colleague who might feel the loss 2.50 times more than gain, his expected value is negative e.g. e.g. -$25 [0.50($200)+0.50(2.50*-$100)]. Given the current outlook, there’s definitely a rising suspicion that global growth is slowing and that various risk factors, including an ongoing trade war between the US and China, may create headwinds in 2019. However, it may not be easy for a common investor to rationalize the facts and even if a professional does, she won’t buy in. For the most individuals when it comes to portfolio decisions under uncertainty, it gets close to flipping a coin with some information e.g. analyzing the risk that the future could deliver more downside surprises, but the opposite is possible as well. Some people tend to react fast in their portfolio and lock in losses if they see a headline, “the next recession is coming in 2019, and with it a bear market loss of at least 40-50 percent.” whereas others may wait too long even if a recession in inevitably apparent to avoid the regret of a bad decision.
Related: The Yield Curve Inverted: Now What?
The decision making in financial markets is seldom rational as human beings have informational, intellectual and computational limitations. Even if we supplement the human limitations with computers, we still may not be able to make fully informed and rational decisions because our rationality is bounded by our perceptions, beliefs, and judgments. In reality, investors may react differently for different parts of their portfolio because of mental accounting bias, which leads them to treat investments into “buckets” based on their sources and goals. An investor with high emotional bias and risk seeking attitude with two investment goals e.g. funding college expenses for two kids in 2019 and owning a vacation home in 5 years may react differently to the recent market downturn based on the size of allocation and the probability of meeting those goals.
Advisors are often vexed by their clients’ decision-making process and reactions when it comes to allocating their investment portfolio. In designing a standard asset allocation model with a client, advisors first seek the inputs to a risk tolerance questionnaire, then discuss the client’s financial goals and constraints, and finally recommend the output of an optimized portfolio. Although this process may work well for some investors, it often fails for individuals, who are susceptible to behavioral biases. In a common scenario, a client demands, in response to short-term market movements and to the detriment of the long-term investment plan, that his or her asset allocation be altered.
Instead of adopting a portfolio optimization model that only matches an investor’s age and risk tolerance category, we recommend a Goal-Based Investing Approach along with the elements of Behavioral Finance to identify an investor’s specific goals, risk tolerance and mental accounting associated with each goal, as well as the management of shortfall risks – the risks that the portfolio will fall short of the various goals.
At Convex Capital, we offer a suite of Behaviorally Adapted Portfolios (BAM), which incorporates practical use of behavioral finance in asset management. The framework of BAM combines, (a) Convex Risk Number Algorithm (CRNA) – a unique identifier for a client with risk and behavioral DNA, (b) Investor’s Goal’s and (c) Investor’s Value Function, which gives a reference point of loss-aversion bias and investor’s preference of avoiding losses as opposed to achieving gains.
In the volatile markets with glaring headlines that can create trauma for many clients, we believe they would be well served by adjusting their asset allocations to account for their various goals and behavioral biases. By doing so, they would stand a greater chance of adhering to their investment programs and enjoy better long-term investment results without the risk of what Ben Carlson said :
Short-Term Thinking With Long-Term Capital”.
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