Loss Aversion

Think about the following scenario - Your friend will flip a coin. If it is tails, you lose $100. How much do you need to win if it is heads to take the bet?

Most people say somewhere between $180 to $220. In a perfectly logical world, you should accept the bet if heads results in you receiving $100.01; however, this is not the case for most people. This is because the pain caused from a loss is greater than the happiness caused from a gain.

In The Art of Thinking Clearly the author, Rolf Dobelli, writes the following:
Losing $100 costs you a greater amount of happiness than the delight you would feel if I gave you $100. In fact, it has been proven that, emotionally, a loss “weighs” about twice that of a similar gain. Social scientist call this loss aversion.

In the investing world, risk and potential return go hand-in-hand. There is no “limited downside with huge upside” investment. Return is not a possibility without taking risk. Due to loss aversion, each person usually has a slightly different answer to what risk-return tradeoff they can handle. Furthermore, this is effected by risk capacity. That is, the amount of risk one can actually afford to take. (The risk capacity of a single 20 year old with zero debt is much different than the risk capacity of a 40 year old with four infant children regardless of their risk tolerance.)

The best investment strategy is one that is specific to the individual. This has to take into account a person’s individual outlook on the risk-return tradeoff, which will almost certainly be affected by loss aversion. 

Three Questions

I recently emailed my fellow authors of this blog, Bryan and Luke, three questions pertaining to college, interviewing, and working as a financial planner. After getting back responses, they asked what my opinions were on the questions. Below are the questions and each of our responses verbatim. I know it was beneficial for the three of us to reflect on our experiences, and I hope it is helpful to others as well.

1)      If you could experience college again starting with your freshman year, what would you do differently as it relates to your career and professional development? 

Bryan: Not focus on social aspects, teach myself to read sooner than I did, find multiple mentors
Luke: If I could experience college again starting with my freshman year I would would spend a great deal more on self-education. It has not been until recently that I have begun to treat education as an ongoing process - one that does not start and end at specific periods of time (the common work-day, a college course). I would treat college and the courses I took as almost supplemental to my overall common goal(s).
Joe: I would take two specific actions. One, look to outside resources for information. A majority of my learning came from the text or the professor. I would reach out to professionals, read blogs, etc to gain a more complete understanding of a subject area as opposed to a solely academic understanding. Two, develop better relationships with my professors. While I did meet with some professors outside of the classroom, I would meet more one on one and seek out their advice more often.

2)      What is your number one piece of advice for the interview process? 

Bryan: There are a set number of questions that I can almost guarantee will be asked: “tell me about yourself?” “why do you think this is a good fit for you?” Learn to answer these questions in your sleep. I call it “the pitch.” After you’ve made your pitch, you can focus on listening to the interviewee’s reactions and trying to see if there is a connection, similar to dating.
Luke: My number one piece of advice for the interview process is to make it absolutely clear what you are looking for, as long as you know what that is. The genuine explanation of what you want to dedicate the next stage of your life to will go an incredibly long way if it aligns with your future-employers views. In my opinion, having the "I'll settle for anything" attitude is a waste of time from both parties perspective. 
Joe: Prepare for non-financial questions. Admittedly, in my very first interview the question “tell me about yourself” caught me a bit off guard. I was prepared to talk about my investment philosophy, the type of business model I was looking for, the role and development track of the firm, etc, but I did not consider basics until after my first experience. In my limited interviewing experience I came to learn that employers are more concerned about finding out if they want to work with you as a person compared to your technical skills. In summary, based off what I faced my number one piece of advice for the interview process is to be prepared to talk about yourself in a more conversational manner, and less the formal “where do you see yourself in five years” type questions.

3)      What is the most significant thing you have learned, general speaking, since starting your current job? 

Bryan: All the branding and technical skills in the world can not make a client like you or trust you. It doesn’t matter your firm name or your job title. Yes, clients now have teams to work on their cases; but they signed up initially because they liked and trusted the individual advisor whom they first met. When referrals happen, they aren’t normally referring the business entity; they are referring the individual they trust and like as a person.
Luke: The most significant thing I have learned since starting my current job is the importance of communication and empathy. So much emphasis is placed on the academic side of the business and not enough at figuring out how to resonate with people and build lasting relationship. I have found participating with seasoned individuals in the field to be the best way to accelerate the learning process.
Joe: Peace of mind is what clients want most. Whether they have $100,000 or $100,000,000, they are looking for an advisor that they can trust and enjoy working with. A close second would be that it is your own responsibility to take the initiative. While a good mentor will be helpful and keep you in mind, sometimes you have to find opportunities to add value to the firm yourself.

When I emailed these questions to Bryan and Luke, I was not planning on sharing them, and I would guess they didn’t factor that in when writing their responses. We did this exercise for our own reflective purposes; however, hopefully these unedited thoughts are even more insightful because of their spontaneity. While many of our posts take days to develop, this one is a bit less dressed up, and for that reason I would imagine it is extremely candid -  something we strive for when writing this blog. Additionally, Bryan, Luke, and I have all taken different paths to a similar point so hopefully that makes this question-and-answer post that much more beneficial for others. 

Frame-of-Reference Risk

The most ubiquitous challenge I have faced that I was not aware of during college is what Roger Gibson calls frame-of-reference risk. Essentially, frame-of-reference risk consists of individuals mistakenly comparing their globally diversified portfolios to the S&P 500. 

The value of holding a globally diversified portfolio is straightforward for most: in addition to the old adage of “not putting all your eggs in one basket,” it results in a more favorable risk-return tradeoff. However, Roger Gibson suggests that this often increases frame-of-reference risk. 

A table best illustrates the problem:

(this is a simplification. assume equal weighting)

In both scenarios the individual is comparing the return of the portfolio (8%) to U.S. Stocks return. In situation A they like what they see. In situation B they do not. (And in fact want to invest more in the best asset - the opposite of what rebalancing calls for.)

Considering the nature of the media in the United States, this is not surprising. Turn on CNBC and it is feast or famine with the Dow Jones Industrial Average and the S&P 500; either the sky is falling or we are all going to be rich. This has been particularly relevant the last several years as the United States stock market has performed well while most other countries have struggled.

Josh Brown wrote a post recently summing up frame-of-reference risk to a tee. Here it is verbatim:

I had dinner last weekend with a financial advisor friend who works on a large wirehouse team based here in New York. Last year “was a major pain in the ass” he told me. He had to remind his clients again and again about the wisdom of global asset allocation while the S&P gained 14% and the rest of the world slumped.

Convincing someone that there is a right way to invest for the long term is hard enough, “re-closing them on our approach every few months is nearly impossible,” he said. I agreed with him. I spent a lot of last year blogging about the frustration among professional wealth managers borne of the huge dispersion between US and foreign stocks. As James Osborne says, what works over most years doesn’t work during every year.

“All the data I could come up with to prove the truth wasn’t enough. People don’t want to see the data when there’s a party going on and they feel left out.”

This year is a different story, he tells me. He got an email the other day from a client to the effect of “Thanks for keeping my portfolio intact and not listening to me when I complained.” Supposedly he had kept the guy from an all-in bet on US stocks just before Christmas. The US stock market is now flat with where it was the first week of Thanksgiving. International stocks have gone berserk to the upside.

So far this year, the power of a global portfolio has reasserted itself, right on schedule – just at the moment where it looked like there was no reason to allocate outside the “best house” ever again:

table via Bank of America Merrill Lynch

The reality is that foreign stocks and US stocks take turns outperforming each other in roughly four year increments. The last such timeframe where foreign developed equities beat the S&P was from 2003 to 2007. There’s no way of seeing the next such streak coming. The first five months of 2015 could be a blip or the start of something bigger.

The point is that it’s likely a diversified portfolio, if history is worth anything at all, will ultimately reward the investors who can stick with it. Even through years like 2014. “They can judge me against the S&P 500 this year if they want,” he said with a laugh.

If you fired your advisor last year to run off and join the Circus of What’s Working Now, don’t be surprised if you find yourself making yet another change in the near future when the grass turns out not to have been greener.

Frame-of-reference risk is basically a simplified version of applying home-country bias to this asset quilt:

via J.P. Morgan Asset Management

When the green box (large cap, represented by the S&P 500) is below the asset allocation box, individuals love diversification. See 2008. When the green box is above the asset allocation box, as it has been the last six years, individuals question the allocation decisions, especially when all you hear from the television shows is “the Dow sets a new high!!”

With diversification, one will never have a portfolio equal to the worst performing asset class, which would have occurred in 2002 if one had held solely the S&P 500; however, one will never have a portfolio equal to the best performing asset class either. While “don’t put all your eggs in one basket” intuitively makes sense, it is easier said than done. When I was coming out of college I erroneously believed diversification was a no-brainer. It certainly is the top strategy in my opinion, but as the advisor in the Josh Brown article stated, “People don’t want to see the data when there’s a party going on and they feel left out.” This is the challenge for advisors: through communication and managing expectations, helping clients avoid improperly benchmarking themselves to their home country’s large cap stocks when they hold a more diversified portfolio.