Shedding the shackles of loss aversion

While psychological biases aren’t necessarily irrational, it is important to consider how they could impair one’s ability to make decisions. And when it comes to short-term investment, loss aversion could be playing an outsized role.

That was the point made by experts from PIMCO in a recent commentary on biases in cash and short-term investing. “In short-term investing, we aim not only to preserve clients’ capital but also to limit volatility, and we believe addressing biases like loss aversion can help us achieve both goals,” said Jerome Schneider, head of Short-Term Portfolio Management.

Referring his team’s process, Schneider described how using a team-based approach limits bias. That includes incorporating unique views and experiences — often in sectors outside of the cash and short-term management space — from different members of the team. Along with input from the firm’s analytics group, the team approach allows for a healthy challenge of market norms, followed by portfolio adjustments as needed.

“Our risk management group also plays an important role by asking questions … to improve objectivity and help discover potential biases in portfolio positioning,” Schneider added.

While loss aversion can steer lead investors astray by prompting poor risk/return decisions — pushing them to avoid risk more than is strictly necessary — there are ways to counter this tendency. According to Jan Faller, Portfolio Risk Manager, Alternative Investments and Emerging Markets, PIMCO tries to pre-empt biased investment decisions by “developing hypothetical forward-looking stress scenarios that represent adverse market outcomes for investment strategies,” essentially letting them pin down how much of a loss can be tolerated during an adverse scenario.

They also manage loss aversion by analysing performance outcomes after an investment decision is made. One part of the analysis, measuring, “compares how a drawdown differs from expectations and can be expressed in probabilistic terms.” The other part, reminding, involves looking at a portfolio and confirming that it had tolerable risk profile that was also appropriately compensated at the time of the initial investment.

But Faller noted that to truly get over their bias, investors may need a dose of bitter medicine. “It may require an explicit act to overcome loss-aversion bias — bridging the gap between the forward-looking hypothetical willingness to accept a potential loss and living through a drawdown in real time,” Faller said.

While loss aversion can bias decisions, Schneider argued that it’s not necessarily irrational, but is in many cases structural. One example, he said, is investors’ preference for traditional money-market funds and Treasury bills despite the existence of other strategies to manage short-term assets. Noting that money-market funds held more than $3 trillion at the end of March, he said that investors are likely seeking to hold liquidity amid dramatic bouts of market volatility. With a host of investing biases keeping them in those funds longer than they intended, they are likely to “miss out on potential opportunities for higher returns as they develop.”

“[V]ehicles such as money market funds can be appealing to invest one’s cash and wait out market turbulence,” Schneider said. “However, investors may want to consider that the return on these funds generally comes mainly from yield − often below benchmark rates − rather than from a combination of yield and capital appreciation.”

Follow WP on Facebook, LinkedIn and Twitter