By John De Goey, CFP, CIM
Special to the Financial Independence Hub
Prospect Theory is a concept that explains how people react when faced with gains and losses in the markets. The early research that went into it was done by Amos Tversky and Daniel Kahneman, two prominent social scientists. The latter went on to win the 2002 Nobel Prize in Economics and write the runaway international bestseller ‘Thinking Fast and Slow,’ which deals with human quirks in behaviour and decision-making. The broad subject is referred to as Behavioural Economics (BE).
I find it fascinating that many people who give financial advice are unaware of the BE research or, if they are aware, do nothing to incorporate it into the advice they give. The implications of the old saying that those who ignore the lessons of history are condemned to repeat them are enormous.
Investors are feeling cocky
That’s especially true with Prospect Theory, which is vitally important in the summer of 2021 because markets have been on an absolute tear. The result is that investors are feeling confident and cocky. One might even say that many have let their guard down. When things go up with so few meaningful interruptions and no specific, readily identifiable storm clouds on the horizon, a dangerous kind of comfortable complacency might set in.
Many people I speak with these days seem unconcerned by the recent run-ups. Despite a series of potential danger signals such as inflation, deflation, the Delta Variant, and implications of climate change, they seem unperturbed.
Kahneman and Tversky showed that, for mostly emotional reasons, people put more weight on perceived gains over perceived losses and that, when presented with a choice offering equal probability of outcome (i. e., a gain of $1,000 vs. a loss of $1,000), most will choose the potential gains.
Advisors as Behavioural Coaches
For that reason, Prospect Theory is also known as the loss-aversion theory, and it offers a simple example of the risk associated with Optimism Bias. Simply put, people like to focus on positive outcomes: often to the minimization or exclusion of other possible ends.
Here’s the thing. Research shows that people generally feel the pain of a loss about twice as acutely as they feel the joy of a gain. If advisors are serious about their role as “behavioural coaches,” then there must be a role to play for placing a portion of clients’ portfolios into products that are negatively correlated – things to go down when markets go up – and vice versa.
Stated differently, if there’s an outsized benefit in avoiding a big loss, it stands to reason that putting a portion of a client’s money into an inverse product (something that goes down when markets rise and rises when markets drop) would provide an emotional benefit: even if it only works half the time!
The case for Hedging
No one knows what the future holds, but if in early 2020, a product with these characteristics was put into a client’s account with a two-year maturity and a 10% barrier (meaning the most you could lose is 10% if markets go way up), and 50% inverse participation (meaning the client could make up to 50% if markets go down by that much), then there’s a case to be made for the advisor having proactively and practically managed (i.e., hedged) a significant behavioural risk. This is an example of how a student of Prospect Theory might claim to know the research, but nonetheless fails to act on it. Obviously, the utility of such a strategy is circumstantial and depends largely on whether markets go up or down in the interim.
No one knows what the future holds, but those in the situation noted above will have lost 10% of their invested principle if they had invested in these notes. Then again, if there is a significant drawdown between now and early 2022, they might actually be the only people in their circle who would have made money in a severe bear market.
Here’s the kicker. The scenario I just described is what I’ve been doing in my practice. I continue to worry that there are significant risks associated with present market valuations. To date, my clients have lost a bit of money on their notes, but no matter how much markets rise from here, they cannot lose any more. Meanwhile, we still have about 140 days until the notes mature. A lot can happen. Risk is real.
John J. De Goey, CIM, CFP, FELLOW OF FPSC™ is a registrant with Wellington-Altus Private Wealth Inc. (WAPW). WAPW is a member of the Canadian Investor Protection Fund (CIPF) and the Investment Industry Regulatory Organization of Canada (IIROC). The opinions expressed herein are those of the author alone and do not necessarily reflect those of WAPW, CIPF or IIROC. His advisory website is: www.standupadvisors.ca.