The recent example of investors’ aversion to losses
Behavioural economists and psychologists have shown that because of our aversion to losses, humans have shunned investments where they would have benefited from strong long-term returns. The share market is an example of this. Compared to other asset classes, share ownership is lower, despite the superior long-term returns. Some economists have labelled this behaviour irrational and the actions of investors over the past few weeks has provided a demonstration of this.
September was a month in which the Evergrande saga was front and centre. Evergrande is, or was, China’s largest real estate developer. Stories about contagion and a broader systemic impact flooded the press. Markets were on edge. This had followed recent, similar reactions to China’s crackdown on profits from education and video game use among children. Investors fled China and broader emerging markets.
However, in September, the FTSE China A50 Index was among the best performing country indices returning 6.21%. The fall in the MSCI Emerging Markets Index of 2.84% was less than the 3.05% fall of the MSCI World ex Australia Index and the 3.56% fall of the S&P 500 Index. It appears Western investors, as evidenced by flows in China ETFs, had over reacted.
We think there are four behaviours, biases or theories that behavioural economists have uncovered that explain Western investors’ retreat from China equities over the past month despite the returns of the index.
1 – Prospect theory (the human response to losses is stronger than to gains)
2 – That feeling of regret
3 – Availability
4 – Adjustment and anchoring.
Understanding these can help improve judgements and decisions.
Prospect theory or the human response to losses is stronger than to gains
Consider these two problems (these are summarised from Daniel Kahneman’s Thinking, Fast and Slow).
1 – You have been given $1,000.
You are now asked to choose one of these options:
50% chance to win $1,000 OR get $500 for sure
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 to both problems is $1,500. Most people are risk averse in problem one and accept the sure $500. However, in 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. This is a principle of prospect theory. According to Nobel Laureate Daniel Kahneman this process has an evolutionary history, “Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.” This might have helped us in the wild, but its results in the investment world vary. Investors must evaluate and assess company collapses, inflation prints, company results and future prospects.
The options investors face involve a risk of loss and an opportunity for gain, and they must decide whether to accept this risk. Prospect theory assumes individuals will avoid risky assets. For example, Behartzi and Thaler (1995), pondered why individual investors continued to shun stocks even though their real returns had been about 7% per year since 1926. They attempted to determine what ‘premium’ people would pay to consider this high returning, albeit higher risk investment option and found individual investors were unwilling to accept variability of returns even if the short-run returns have no effect on immediate consumption. You can only imagine how Behartzi and Thaler’s individual investor would consider China, especially in consideration of the current geopolitical environment.
Investors have always appreciated regulatory risk in Chinese equities. Emerging markets equities, including China A shares, have historically traded at a discount to developed markets. In 1995 when Behartzi and Thaler wrote their paper, many people did not have exposure to emerging markets. Nor were they yet exposed to long term investing for pensions. This is three years after the superannuation guarantee had been introduced in Australia. Since then share ownership has increased and Australian investors, through their superannuation, which is restricted from immediate consumption, have become more comfortable with the volatility that comes with stock market investing. We wonder if Behartzi and Thaler did their research today, would they find a change in the level of risk aversion? Now, for those investors that were brave enough to have an allocation to emerging markets and then panicked – do they now have feelings of regret?
That feeling of regret
Regret has been defined as “the pain we feel when we realise that we would be better off today if we had taken a different action in the past.” When you are investing, you are exposed to possible future regret and people consider this when they decide to allocate their money to an investment, fearing losses more. This leads to a process that behavioural economists call ‘narrow framing’. Narrow framing is the process of using information that is most accessible. For example, it is natural in the current market environment to consider short-term returns, daily price movements of stocks or immediate market reactions to news. Unfortunately, losses occur more often in risky assets when short term returns are considered and for investors allocating to these risky asset classes these could lead to potential regret should losses occur and the gamble turns out poorly or you panic and miss potential upside.
This is where information filtering is paramount. Investors need to be aware of who is making the message and their motivations, as well as and being aware of their own inherent biases or behaviours that make us make poor decisions. We all have these behaviours and one is ‘availability’.
Availability is the decision making process of assigning the likelihood of an outcome by the ease with which instances can be remembered.
According to Kahneman and his long time research partner, Tversky, “one may assess the risk of heart attack among middle-aged people by recalling such occurrences among one’s acquaintances.” This leads to biases, often overestimating the likelihood of occurrence.
Recent occurrences too are likely to be more readily remembered and therefore will increase the estimation of occurrence. Furthermore, the impact of an experience will affect decisions. For example, the impact of seeing (or even hearing about) a shark attack will have an impact on your assessment of the probability of a shark attack. Memories of March 2020 are still fresh in investors’ minds. Property was a key ingredient leading to the GFC. Is it any wonder investors are jittery?
Adjustment and anchoring
Finally, it is useful to remember we are bad at assessing risks and nothing illustrates this more than the way we anchor and adjust our estimates. The experiment that best highlights this involves two groups of students. One group is asked to estimate the answer for:
1 x 2 x 3 x 4 x 5 x 6 x 7 x 8
The other estimates the answer for:
8 x 7 x 6 x 5 x 4 x 3 x 2 x 1
Kahneman and Tversky hypothesised that adjustments we make quickly when estimating are typically too low, so the resulting guess will be lower than the real answer. Furthermore, because the result of calculating an estimate is based on a starting point, which is established in the first few steps of making an estimate, estimates will be higher in the descending sequence than the ascending sequence. This is because the descending sequence, anchored by a higher starting point, should give a higher ‘estimate.’ The results of Kahneman and Tversky’s experiment confirmed both predictions. “The median estimate for the ascending sequence was 512, while the median estimate for the descending sequence was 2,250. The correct answer is 40,320.”
As investors we may have been anchored by news of China’s largest property developer. The estimation of the impact on China A-shares may have been overestimated.
Applying this to the current crisis
Markets move with such speed and velocity it is difficult to ‘anchor’ risks. It is almost impossible to adjust with so much information and misinformation circulated. Many adjectives and considerable emotive language is used, not just to describe the Evergrande crisis, but the Delta lockdowns and geopolitical tensions.
It is important to look past the positive and negative commentary and concentrate on your long term goals. In markets, unpredictability is the only constant. 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.
It is interesting to note, in Thinking, Fast and Slow, when participants in Kahneman’s experiments are “instructed to ‘think like a trader,’ they become less loss-averse and their emotional reaction to losses (measured by physiological index of emotional arousal) was sharply reduced.” Maybe that is what Buffett means when he says, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” He also says his favourite holding period is forever.