Thought Leadership (Professional Only)

Tapping into behavioural biases can create repeatable returns

Classical economics assumes the existence of a group of perfectly rational human beings who carefully weigh up the pros and cons of any financial decision. But these mythical beings have been hard to find in real life.

11 December 2014

Classical economics assumes the existence of a group of perfectly rational human beings who carefully weigh up the pros and cons of any financial decision. But these mythical beings have been hard to find in real life.In truth, people take sometimes irrational short cuts to help them make financial choices. This realisation has led to the development of alternative theories aimed at identifying these short cuts or ‘heuristics’ – speedy ways of solving difficult problems.

Although heuristics have long been known about, it has never been clear how investors can profit from them. This article draws on the work of behavioural economists to identify three groups of heuristic biases – prospect theory, extrapolation and herding, and ambiguity aversion and availability bias – and then looks at the financial strategies
that can profit from these hard-wired behavioural patterns.

1. Prospect theory
The systematic inconsistencies that individuals bring to their decision-making processes have led to the development of prospect theory1. One key finding from this has been that investors are loss averse2, suggesting that there ought to be excess demand for insurance strategies that reduce downside risk. In other words, the average investor should be willing to pay over the odds to protect themselves from harm. If the behaviourists are right, it ought therefore to be possible to extract an excess risk premium over time for a disciplined strategy that underwrites that risk.

We believe there are two distinct types of investment themes that can be used to exploit
this psychological intuition:

a. Shorting volatility on equity markets
The average investor not only tends to exhibit loss aversion, but also to overestimate the probability of extreme events. This leads to anxiety about a possible loss of capital. As a result, there is consistently high demand for financial assets which can avoid the discomfort caused by significant capital losses. One example is the equity put option. There tends to be a greater demand for puts than for calls as most investors are natural holders of risk assets (like equities). Risk aversion means they prefer to protect these assets from falls, rather than provide themselves with the opportunity for further upside by buying calls.

The heavy demand for this insurance means investors have a tendency to overpay. Consequently, a strategy that systematically underwrites the insurance they seek should earn a positive premium over the long term. On the other hand, the underwriters are themselves likely to suffer losses in the event of a macro shock. This tends to result in a low, even distribution of results with larger tails (‘high kurtosis’), particularly to the left (‘negative skew’). Despite these infrequent outsize losses, the strategy should still generate a small and generally consistent performance overall. A similar pattern of returns can be seen with currency carry trades (Figure 1).

 

b. The foreign exchange carry trade
Currency carry is the return an investor can get from borrowing in low yielding currencies – those where interest rates are low – and investing the proceeds in higher yielding ones3. On the basis that investors generally dislike inflation, they should require a lower premium (interest rate) for holding a currency managed by a central bank with a more credible record on containing inflation. Conversely, higher yielding currencies should naturally be perceived as riskier.

It follows that an investment strategy that systematically withdraws liquidity from safe assets (in this case, currencies associated with low interest rates) and allocates it to more risky assets (currencies carrying a higher rate) is equivalent to an insurance policy that underwrites a broad systemic risk. This is because, at times of market stress, it will provide liquidity for investors in risky assets who wish to sell and seek safety in higher quality assets. The expected currency carry therefore becomes the risk premium offered to the provider of insurance against that systemic risk.The principal risk of this strategy is that it is sensitive to liquidity shocks and therefore subject to significant drawdowns. It also exposes the investor to idiosyncratic country risk, which can increase in the event of any big slowdown in global growth (Figure 1). Even so, as with the previous strategy, despite the occasional large loss, an investor should still enjoy a consistently positive return overall.

1David Kahneman and Amos Tversky, ‘Judgment under Uncertainty: Heuristics and Biases’, Science, vol. 185, no. 4157 1974; and D. Kahneman and A.Tversky, ‘Prospect theory: an analysis of decision under risk’, Econometrica 47. 2A simple example of loss aversion (and framing) is that it is easier to encourage people to pay a bill by penalising late payment than by offering them a discount for early payment. Loss aversion is in fact equivalent to the traditional concept of the diminishing marginal utility of wealth.3This is an uncovered interest rate arbitrage, which should not exist in theory since the currency with the higher interest rate ought to depreciate relative to the currency with the lower rate. This, however, ignores the actions of central banks and governments which may see it as in their interest to ensure that this trade rewards investors.

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Important Information: The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change.  To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 31 Gresham Street, London, EC2V 7QA. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.