The fear of loss is one of the most powerful forces driving investor behaviour. A rich history of academic research has proven that human behavioural biases can lead to irrational or sub-optimal decision making. In investment markets these biases can result in systematic mispricing of assets which the independent minded investor can exploit to achieve above market returns.
Losses are inherent to the investment process
One of the popular quotes from Warren Buffett states "Rule No.1: Never lose money. Rule No.2: Never forget rule No.1". Yet Buffett, as with all successful investors, has experienced and continues to experience investment losses.
The important point for investors is to avoid a permanent loss in their total portfolio value. Risk is inherent to investing and even the best investors expect to incur losses on individual investments from time to time. Positive portfolio returns are generated by ensuring the investment wins are greater than the losses.
All investing comes down to an assessment of the risk/return trade-off and only by identifying mispricing of this trade-off can a portfolio be expected to achieve above market returns. In asset classes such as government bonds, which make up the low end of the risk spectrum, mispricing of the risk/return trade-off is rare and there is limited opportunity to generate ‘alpha’ (above market returns).
Mispricing of the risk/return trade-off is much more prevalent in equity markets and while there are a range of factors that can driving mispricing, we believe the fear of loss is one of the most powerful. In the remainder of this article we explain the human behavioural bias driving this fear and demonstrate how it has contributed to the systematic mispricing of stock prices.
people are hard-wired to misprice the risk of loss
The academic field of behavioural finance was pioneered by Daniel Kahneman and Amos Tversky (Kahneman is a psychologist who was awarded the Nobel Memorial Prize for Economics in 2002). Together they identified a range of human biases that influence our decision making and, which in the field of finance, can lead to sub-optimal investment decisions. These biases include confirmation bias, present bias, hindsight bias and the endowment effect.
Researchers in behavioural finance often test scenarios with groups of people as a way of gaining insights into the biases that drive human decision making. An example of one such scenario is the following:
You hold a lottery ticket with a 50% chance of winning $1,000. Somebody offers to buy the lottery ticket for $400. What do you do?
Research has demonstrated the majority of respondents would sell the lottery ticket for $400 even though the expected return from retaining the ticket is $500 (50% probability x $1,000 return). This seemingly irrational behaviour was initially explained in terms of ‘utility theory’, which suggests that less value is placed on every incremental addition to wealth. In other words, people value the certainty of $400 more than the 50% probability of $1,000.
Further research, however, using differently constructed scenarios, demonstrated that people do sometimes select the option with the highest expected return. This paradox led Kahneman and Tversky to identify human psychology as the key factor driving the behaviour in the example above. According to their 'theory of regret', people make decisions to minimise regret rather than to maximise utility. Regret is also imaginable and people’s desire to avoid losses exceeds their desire to secure gains.
This behavioural bias is equally applicable to investment markets, particularly listed stocks where the fear of loss can lead to significant price volatility. We find that companies facing some form of bad news (or where the underlying business risks are currently apparent) will have the downside risks factored into their stock prices much more than the potential upside opportunity. It is for this reason that some of our clients are occasionally surprised when we acquire stocks that are subject to negative media commentary.
One of my favourite sources of investment ideas is the list of most shorted stocks or those stocks that the market most expects to fall further in price.
Profiting from investors’ fear of loss
The practice of shorting stocks is one aspect of the market in which we find fear leading to significant asset mispricing. These companies are often the subject of highly sensationalised media commentary and exaggerated claims of business decline.
In order to demonstrate the impact of shorting on asset pricing, we conducted an analysis of the most shorted stocks (relative to the quantity of shares outstanding) over 1 year intervals for the last 5 years.
As can be seen from the table above, many of these stocks went on to achieve strong positive returns over the following year. In fact, as a portfolio of equal-weighted holdings, the stocks outperformed the index over a one-year horizon in four out of the five years.
If one were to have adopted a portfolio strategy involving buying the six most shorted stocks at the beginning of each year, then selling after one year and re-investing in the most shorted stocks at that time, the portfolio would have delivered a gross return of 136% over 5 years (compared with a 29% return for the index).
Of course it would be both naive and dangerous to build a portfolio simply on the basis of the most shorted stocks as the past performance of any strategy cannot be guaranteed to repeat into the future. We do, however, find the most shorted stocks a useful means of screening for potential mispricing opportunities. Given the higher risk profile, we expect these types of investments to comprise less than 20% of an overall portfolio strategy. The key is to not fear a loss as long as you are making an investment decision with a sound understanding of the risk/return trade-off and you have diversified your risk exposures.
DISCLAIMER
This publication is issued by JJT Advisory Pty Ltd and is intended to be general information only without taking into account the investment needs, objectives and financial circumstances of any particular investor.
Past performance is not a reliable indicator of future performance.