There is one cost of the global financial crisis that has been entirely overlooked. It is hidden, insidious, undermines investment decision-making and gnaws away at portfolio returns.
That cost is the attention consumed by information overload and the crisis has brought a lot of new information for investors to attend.
The news is not just about corporate collapse. Rather, investors have had to grapple with the question of the value of the risk-free asset. Sovereign debt forgiveness has already been agreed for a developed European sovereign; the prospect of default discussed in another. The option of not making coupon payments was openly debated in a US Congress. This has been a completely new information flow – statutes, treaties, constitutions – for already information-overloaded investors to take in.
Herbert Simon was a scientist who coined the expression ‘bounded rationality.’ He recognised that the human ability to absorb information, to weight it appropriately and to update one’s knowledge correspondingly, was subject to constraints. Despite these limitations, however, human beings have emerged as rather smart because of their ability to economise the cognitive effort required to make decisions through the use of mental short-cuts. These short-cuts, known as heuristics, do much of the heavy lifting when it comes to understanding the world and in identifying how the various pieces of information fit together.
Thanks to heuristics, one does not have to waste too much time with repetitive,
and often superfluous, assessment and deliberation; one can apply one’s intellect directly to an inference based on a few cognitive cues. For instance, investors need not analyse the minute implications of a parliamentary decision in Berlin or Athens for the long-run discounted cash-flows from a security; they needed only to classify it as ‘risk-on’ or ‘risk-off’ and act accordingly. In most cases, this fast-track thinking allows investors to get an enormous amount of work done, the vast majority of which is perfectly satisfactory. The problems only occur when the short-cut sends decision-makers the wrong way and, because many people use the same or similar short-cut, they err in the same direction at the same time.
One such short cut, if not the most important of them, is the reference point. When faced with a new situation, it is infinitely easier and faster to evaluate it against a starting point instead of from scratch. When asked how much they enjoyed the movie Kung-Fu Panda 2, people will typically make some reference to the first movie: it had a weaker story; it was funnier, etc. What people will be reluctant to do is to evaluate from the bottom up their appreciation of the animation techniques, the casting, the voice characterisations, the musical score, and the script. That would take way too much time. So, it is more efficient to start at Kung-Fu Panda 1 – the reference point – and adjust from there. The saving in terms of information processing time is undeniable and the conclusions are valuable as long as the right reference point is chosen. However, why should the first movie be the best reference point? It is certainly the one that comes most quickly to mind, but why should it be the best?
The animated antics of the high-kicking Panda, on his second outing may have undershot the artistic brilliance of the first film on all measures and disappointed the reviewer, but it could still be the best film to screen that day. The reference point is only useful if it is the right one. In financial markets, the reference point that investors use most frequently is the market price. There is thus a tendency to perceive a security that has fallen in value from where it was as ‘cheap’, and one that has risen as ‘expensive’. Even though most professional investors concede that this is not the appropriate way to judge value, all will confess to using some sort of scanner or filter that uses price change over a pre-determined period as a way to identify securities of interest. However, as the reference point is not the best one, it does not necessarily help to reveal the best security.
Another often-used reference point is the historical cost of a security. The price
at which one bought a security is even less meaningful as measure of value as
the market price and therefore a useless reference point. Yet investors struggle
to ignore it because it is the threshold between profits and losses. All too often, this reference point exerts a powerful influence on the decision to liquidate or to hold an engagement. This is because being right matters a lot for investors, or more accurately put, not being wrong. For some, being right on an individual decision is all that matters. It is this preference that gives rise to the disposition effect – the tendency that investors display to be more prone to liquidate an engagement when it reflects an unrealised profit and less prone when it reflects an unrealised loss.
Taking profits proves the initial decision was the right one. This is an outcome investors desire and they are moved to act as a consequence. Even though it might be wiser to hold the security, at least, nobody can ever say that it was wrong to have bought it in the first place. In contrast, to liquidate an engagement that reflects a loss makes that loss permanent.
The proof would then be there for the entire world to see that the initial decision to buy the security was unwise. As a result, investors prefer not to liquidate. They will hold on, even add to it. They will also bend their perception of the situation and of incoming information, to facilitate the decision to hold. Investors are, therefore, not necessarily averse to risk because the decision to hold or not is not determined principally by the risk associated with engagement. More accurately, they are just averse to loss.
The relative propensity to realise a profitable engagement relative to a loss-making one is known as the co-efficient of loss aversion. For the population as whole, it is estimated to be slightly more than 2: 1, but it varies for each individual and according to the size of the engagement; it tends towards 1:1 for small commitments and increases as the size of those commitments grow.
Retail investors are particularly susceptible to a high co-efficient – the decision to sell or hold is very much influenced by the win-loss situation. Research has shown professional investors will typically have a lower co-efficient of loss-aversion than retail investors.
Experience seemingly helps professionals overcome the tendency. However, they do not overcome it completely. There is still ample evidence professional investors not only display loss-aversion but, by examining the subsequent performance of the assets they held compared to that of the ones they sold, it is also possible to show the disposition effect actually worsens performance. Also, when one examines the loss aversion of the worst performing mutual fund managers – the bottom decile – one discovers their co-efficient of loss aversion is not much different from that of retail investors.
Loss aversion goes much further than that just nibbling at investors’ performance at the edges. Investors’ reluctance to realise a small loss can encourage them to take increasingly larger risks in order to escape the losing situation at breakeven. Such behaviour has probably been responsible for some of the greatest disasters in financial history. So it almost certainly played a role in the current crisis, both at its origin and in its persistence. However, by its very nature, it is also present in asset markets to some degree all the time, even in the more banal phases.
Information is supposed to empower investors and allow them to make optimal decisions. However, as investors cognitive ability is subject to constraints, too much information results in overload. In these conditions, especially when the additional information is unfamiliar and complex, investors are more likely to grasp for heuristics in order to fast-track the decision process. They are, therefore, more likely to rely on reference points, not all of which will be useful, and to succumb to loss aversion. Markets deviate from standard rational choice models at the best of times; in a crisis whose main characteristic is information overload, this deviation is likely to be all the greater.
