IN FOCUS6-8 min read

Janus, regime shifts and behavioral finance traps

The global regime shift taking place will produce volatility. Understanding how behavioral finance traps may reduce fixed income return opportunities is essential as monetary and public policies evolve.

02-01-2023
behaviour

Authors

US Multi-Sector Fixed Income Team

Janus is the Roman god of beginnings, transitions and endings. He dictates the path of mere humans’ lives. As the annus horribilis, Latin for “horrible year,” in fixed income fades into the past and we look forward to a new year,it is critical to assess the future return outlook of fixed income. What should investors consider in order to capture as much of the future investment opportunities as possible, especially as the regime shift from fighting inflation to tackling growth concerns ensues? 

During periods of extraordinary market volatility, it is important to understand how behavioral finance traps can interfere with maximizing investment returns. These obstacles can prevent investors from improving future returns by stalling, executing a suboptimal investment idea or even taking uncompensated risks. In the following article, we will examine several cognitive and emotional biases than can negatively affect future performance.

Behavioral finance seeks to explain aspects of investor action that traditional economic theories of investing do not explain. The assumption of financial theories, which state that investing is a completely rational process that can be undertaken with mathematical precision, is incorrect. Investors are sometimes irrational due to biases and misconceptions. At times, mental shortcuts, impulsivity and historical prices and relationships can drive investment decisions. A driving principle of value investing is connected to the concepts of behavioral finance as value investors understand that in the short run, markets are inefficient. Famous value investor Benjamin Graham said, “In the short run, the market is a voting machine but in the long run it is a weighing machine.”Emotions such as greed and fear prevail and lead people to buy high and sell low. The following are the most common post-drawdown behavioral finance traps that affect investors during regime shifts and our suggestions on how to avoid them.

Regret and loss aversion 

Behavioral finance analysis indicates most investors have an innate aversion to losses, even when there is a favorable future economic payoff. Research has shown that the pain of losing money is far greater than the joy of earning money. Selling an investment that has dropped in price is difficult but may often be the right decision. The 2022 market sell-off was widespread and at times indiscriminate. As liquidity receded, sales at times entailed discounts to fair or relative value. This increased the diversity of opportunities in the market not only in pricebut also across the risk and liquidity spectrums of the fixed income market.

During and after abrupt and or substantial volatility, errors of omission increase relative to errors of commission. By evading decision-making, an investor may underperform by missing a great opportunity. This error of omission is driven by regret aversion bias, which is the fear of making a decision that may turn out to be wrong, leading to the feeling of regret. Investors who are loss averse do not have problems making decisions. However, they tend to make the wrong decisions because of emotional factors. The likely outcome of loss aversion is a wrong decision, whereas the likely outcome of regret aversion is no decision at all.

Sunk cost fallacy/Disposition effect

Regret and loss aversion often lead to the sunk cost fallacy that describes the tendency to focus on costs that have already been sustained instead of the benefits one might derive in the future. Traditional financial theory labels these sunk costs as irrelevant with regards to future returns. At times referred to as “asymmetric value function” or “get-evenitis,” the disposition effect is the tendency to hang onto a losing investment for too long. Despite the fancy name, this concept is closely related to loss aversion. The result is investors end up holding onto rather than disposing of a losing position or fund investment, hoping that it will regain its value.

Anchoring bias 

Anchoring bias is a mental flaw that impacts the way a person derives a future price. It results from the first or initial price paid, creating a mental anchor to which all subsequent information is compared. The issue with these mental anchors is that they are purely based on chance with no relation to inherent or intrinsic value. Instead of focusing on future return opportunities, investors get stuck on the current price or the price paid and only get mental satisfaction when a price closer to the original price is realized.

An example of regret, loss aversion and sunk cost fallacy is the refusal to sell a bond that has fallen in price despite an opportunity to use those proceeds to invest in a bond that has had a greater price decline with better potential upside. In Figure 1 we highlight an example of how an investor over the last twelve months could have sold a lower quality bond (TMUS) and paid just 2.19% to buy a higher quality bond (VZ) that had fallen more in price. Note that both bonds are in the same sector with similar liquidity.

Figure 1

Issuer

Verizon (VZ)

T-Mobile (TMUS)

Date Issued

March 2021

April 2021

Outstanding

$4.5 billion

$3 billion

Coupon

3.55%

3.30%

Maturity

March 2051

Feburary 2051

Rating1

A-/BBB+/Baa1

BBB-/BBB-/Baa3

Price January 20222

101.55%

90.92%

Price January 20233

76.40%

71.20%

LTM* max price decline

36.63%

29.59%

LTM* minimum cost to sell TMUS and buy VZ

2.19%

1Fitch, S&P, Moodys. 2January 24, 2022. 3January 23, 2023. *LTM – last twelve months.

Source: Bloomberg. Shown for illustrative purposes only and should not be viewed as investment guidance.

Another example that also includes sunk cost fallacy, the disposition effect and anchoring bias would be selling an asset that has fallen in price in order to invest in something that is significantly less exposed to further price declines. A notable example is the Austrian century government bond. As shown in Figure 2, selling after the price had declined from around $140 to around $100 during 2021 would have been difficult and yet it would have been the right decision as the bond declined almost another 55 points during 2022.

Figure 2

Austrian century government bond

*Republic of Austria Government Bond 0.85% notes due 06/30/2120.

Source: Bloomberg. Shown for illustrative purposes only and should not be viewed as investment guidance

Investing after a regime shift

The global regime shift taking place today results from a significant change in both monetary and public policy. It will produce volatility, which will have a material impact on business investment and the allocation of resources. Increased volatility will cause more disruptions and dislocations and therefore more opportunities for active management. Understanding how backward-looking behavioral finance traps may reduce return opportunities is essential to avoid cognitive biases and maximize the potential future fixed income return opportunity.

Also, as market disruptions and dislocations do not manifest systemically during the initial stages of a regime shift, a nimble manager with a proven history of dynamic sector rotation is best positioned to capture episodic opportunities in stressed industries or non-traditional sectors such as municipal credit. As central banks continue to withdraw liquidity, position size is an important consideration as it is costly for large portfolios to quickly reallocate risk. As the saying goes, awareness is the first step in curing a problem. Hopefully this paper will help to uncover some of the biases that dictate investor behavior and you become a better allocator in the long run.

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Authors

US Multi-Sector Fixed Income Team

Topics

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