Prospect Theory in Today’s Stock Market

So was this week a wake up call for investors that markets are still risky? Of course. But investors already they knew that. They love risk. More importantly, they can't afford not to take it. Day by day, we are inching closer to the time when the Boomers will have to liquidate. But it's not that time yet. So the money pours into the market, and the market itself, facilitated by the merger of exchanges, grows larger and ever more integrated.

You know what that means don't you? The real liquidity crisis, when it comes (18-26 months down the road we reckon) will be much larger, much more destructive, and impossible to contain. It will represent the end of the post-war, post-Bretton Woods experiment with asset inflation as a means to personal wealth-building. It will be nice to own some gold then, preferably a lot.

The incredible irony of what we've seen this week is that most investors almost always do exactly the wrong thing, from a rational perspective, when confronted with "decisions under risk." This shouldn't be that surprising, though.

Human beings, under the duress of fast-moving global financial markets with dozens of virtually untrackable variables, are programmed by nature to do two things. First, they freeze, the way our ancestor used to do on African savannah's thousands of years ago when they saw a big cat on the horizon. You can thank the amygdala, which takes control of the brain at these crucial times, pulling rank on the thoughtful frontal lobes that otherwise makes us distinct as primates.

This temporary coup-de-brain is nature's way of by-passing the frontal lobes to arrest our action before we do something stupid like running for our lives and attracting a lot of attention from other predators. Panic does not promote survival. It's this freeze in our musculature that gives us enough time to tense up our muscles and either fight, or flee.

The second thing human beings do when confronted with risk is seek the action which has the largest possible negative effect on them. Yes, you read that correctly. And here we apologize for getting a bit statistically geeky on you. But as this is the Daily Reckoning, we are pretty sure you won't read this explanation for market behaviour anywhere else. From a novelty perspective at least, it should be worth your time.

The explanation takes us back to that crucially important year in financial history 1979. That was the year Daniel Khaneman and Amos Tversky published the second most cited economics article in academic history, "Prospect Theory: An Analysis of Decision Under Risk."

The paper was a landmark in the understanding of human behavior because it pointed out the tawdry little lie at the heart of classical economic models about human behaviour, namely that people weigh risks with perfect information and then make rational decisions. Wrong! Homo economicus is a complete fiction.

What Khaneman and Tversky showed is that people make two kinds of decisions with respect to risk and reward, and that neither decision is rational. One the reward side, investors tend to overweight certain outcomes, choosing lower returns with higher probabilities over higher returns with lower probabilities. Or, in layman's terms, most investors prefer the appearance of certain, predictable, single-digit returns from blue chip stocks or bonds than the higher but lower probability returns from say, small cap stocks or emerging market bonds.

That investors would over-weight outcomes that are considered certain isn't that surprising. It suggests that capital preservation is psychologically (and financially) more important to investors, than capital growth. The difference today may be that investors-at least the retiring Boomers in the West who make up the bulk of the market-need big capital gains in the next few years to increase their retirement income. This may cause them to take more risk (to make up for past losses) than would ideally be appropriate at this stage in their investment career. But you go to war with the Army you've got, don't you?

What's really shocking from Kahneman and Tversky's paper is how investors approach losses. And the conclusion is inescapable: investors seek it. Or, as the paper puts it, "This analysis suggests that a person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise. The well known observation that the tendency to bet on long shots increases in the course of the betting day provides some support for the hypothesis that a failure to adapt to losses or to attain an expected gain induces risk seeking."

And here we thought investors were seeking alpha, and that global risk premiums were converging toward zero. But no! What you're really seeing is more bets on long-shots. This is, in the paper's own terms, a failure to adapt to the very risky world we invest in. But then again, investors are only people. And this means that in the coming years, we can expect investors not to avoid wealth-destroying beahviours and investment decisions, but to greedily seek them out.

Incidentally, Bill Bonner has a theory about this, which he hasn't given an official name to. His theory is geopolitical, that it is the nature of large institutions (like Empires) to find a way to destroy themselves, that they must do so. Surpluses of any sort (financial, political, caloric) are un- natural. Human beings, as every good student of Greek and financial tragedies knows, find spectacular ways to squander their good fortune.

Tversky and Khaneman show that faced with a choice between a low- probability but high-magnitude loss on the one hand, and higher-probability but lower magnitude loss on the other hand, human beings tend to choose the higher magnitude loss with the lower probability. Or, in layman's terms, that means if you were faced with the choice of a certain loss of $20 or the 30 per cent probability of losing $60, you, if you were like most of the other featherless bipeds on the planet, would choose the 30 percent probability of losing $60.

It does make sense with a weird kind of emotional logic. Faced with the certain loss of $20 or the possible loss (one chance in three) of losing three times as much, investors take the lower probability, higher magnitude event.

But when you apply this statistical, empirical, and psychological finding to the markets-and here we mean equity markets writ large on a global scale, reacting to one another in real-time-the result is stunning. It means you can expect to see people engage in riskier and riskier behaviour, nearly always choosing bigger losses over smaller losses.

"But wait!," you shout. "You're forgetting about probabilities. Why choose a certain loss over a probable loss?

Good question. But perhaps our notion of probable losses is wrong as well. Investors are operating under the assumption that larger losses in today's markets are lower probability events. There is also a wide-spread belief that the larger the markets get and more integrated they become, the lower probability of really gut-wrenching losses. The problem with this academic theory is that it is exactly, emphatically, categorically, wrong.

The theory we refer to is that market crashes are statistically rare and can be modeled on a bell curve, with a standard distribution of price movements. Most movements, in a classic bell curve, would be within one or two standard deviations of the mean. Or, in stock market terms, there would be only a few instances when the market produced dramatically above average or below average returns. Most returns would be rather mundane, and rather predictable. There would be few crashes and fewer still triple digit gains. But the evidence suggests otherwise.

"From 1916 to 2003," Benoit Mandelbrot writes in The Misbehaviour of Markets, "the daily index movements of the Dow Jones Industrial Average do not spread out on graph paper like a simple bell curve. The far edges flare too high: too many big changes. Theory suggests over that time, there should be fifty-eight days when the Dow moved more than 3.4 percent; in fact, there were 1,001. Theory predicts six days of index swings beyond 4.5 percent; in fact there were 366. And index swings of more than 7 percent should come once every 300,000 years; in fat, the twentieth century saw forty-eight such days. Truly, a calamitous era that insists on flaunting all predictions. Or, perhaps, our assumptions are wrong."

And what about this new era? When you combine Mandelbrot's observation with Kahneman and Tversky, you get a picture of increased volatility and risk-seeking behavior. People, faced with more to lose, risk ever more.

The only question now is how large the stakes will get. And our observation on that is that the global equity and asset pot has room to grow. Volatility has been ominously quiet the last few years. It may have returned this week through the backdoor in Shanghai. But don't expect it to make investors more conservative and trigger a rally in fixed income and bonds.

Rather, we may be seeing a whole new level of global speculation, an order of magnitude larger than anything that came before it. This game, the world series of speculation, is the end-game of the experiment with fiat money, money not backed by a real asset. But it would be a mistake, we think, to imagine that the end-game ends now.

The tragedy/comedy has at least one more act and a few years to go. And in that time, we recommend you pull up a chair, pop some corn (if you can afford it at today's prices), and enjoy the spectacle.

We do, however, advise against over-weighting expected certain outcomes... that stock prices always go up, that sovereign governments don't default on their debt... and that investing for the long-term is your best bet.

Just what is your best bet? Cash in while you can, perhaps. Peace of mind makes being a spectator more pleasurable. But, if you're in the markets, or must be in, our focus will continue to be on the higher-magnitude returns that are priced as if they have lower probabilities.

That is, selected punts in small cap stocks and gold juniors promise the largest magnitude returns over the next few years. And is the risk in those asset classes really any higher than what we've seen the last few days? We don't think so. But most people will continue to believe so. And if there's any good news to that, it means you may find mis-priced risk in the market after all.

Dan Denning
The Daily Reckoning Australia

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