Using Behavioral Finance to Make Better Financial Products

Using Behavioral Finance to Make Better Financial Products

The awareness-raising insights of behavioral finance continue to shed new light on the subjective experience of risk. In response, the financial services industry has made significant investments in investor education. The prevailing language of risk and risk tolerance is evolving to reflect the deeper understanding of the psychology of financial decision-making. But the language needs to evolve faster, and financial firms need to extend their response to behavioral finance beyond investor education and into product innovation.

Consider the context. A growing body of research suggests that the average investor defines and mitigates risk in ways that do not align neatly with classical financial theory. Deeply ingrained aversions to loss, risk and ambiguity often lead to investment decisions that can materially and adversely affect risk-adjusted returns. Specifically:

 

  • Loss Aversion – Theoretically, investors should want to gain a dollar as much as they want to avoid losing a dollar. In reality, the risk of loss motivates the typical investor much more powerfully than does the prospect of gain. The pain of losing $1,000,000 far exceeds the satisfaction of earning the same amount. Loss aversion is closely related to the “endowment effect” - people’s tendency to value the assets they own more highly than they value identical assets that they don’t own. Psychologically, this is understandable, but from a financial perspective, loss aversion can lead to suboptimal decisions – for instance, the classic pattern of investors exiting the market at the bottom.
  • Risk Aversion – Modern portfolio theory measures risk acceptance as the additional marginal reward an investor requires to accept additional risk. But the typical investor measures risk not only mathematically, but also viscerally. Reluctant to accept bargains with uncertain payoffs, investors often prefer bargains with more certain, but possibly lower, expected payoffs. The psychological reason behind risk aversion is that uncertainty itself delivers a certain cost or displeasure that people seek to avoid.
  • Ambiguity Aversion -- Investors prefer known risks to unknown risks, even when the choice results in a lower expected payoff. For instance, U.S. investors are significantly overinvested in domestic instruments. Whereas a diversified equity portfolio should arguably incorporate a 50% global allocation, U.S. investors typically invest only 10% abroad. Although U.S. investors are rationally aware that at least some global equities (e.g., European large cap) belong within their portfolios, familiarity leads to an overwhelming favoritism toward U.S. equities.

 

Although they can inspire suboptimal decisions, psychological aversions are not departures from normal decision-making. These cognitive biases are deeply rooted in human evolutionary history, and they shape the ways people make decisions, especially under conditions of heightened uncertainly and ambiguity.

Even as findings from behavioral finance gain mainstream currency, they cannot transform human investors into completely “rational” decision-makers. Ultimately, the best way to offset the impact of psychological variables is to deliver risk-reward exposure that does not irritate an investor’s sense of happiness and wellbeing.

That is the promise of defined-outcome investing, an investment strategy that allows investors to limit their risk-reward exposure to pre-set protection and return levels – for example, market exposure subject to an annual maximum gain of 20% and an annual maximum loss of 15%. Theoretically, most investors should use individual options strategies to deliver a defined outcome experience that fits their needs. In practice, however, direct use of options introduces a high degree of complexity that most investors cannot accommodate. For instance, there are currently over a thousand different options available for sale on the S&P 500.

Several products have emerged to deliver defined outcome benefits without the complexity of direct options investing.  These products include structured notes and fixed index annuities.   However, the structure and performance characteristics of some of these solutions make them unsuitable or inaccessible for all but the most affluent investors.

The typical investor wants and deserves more security, predictability and transparency than most financial products provide.  It behooves the financial services industry to invest more aggressively in product innovations that mitigate behavioral aversions while maintaining broad and balanced exposure to markets. 

 

Joseph Halpern is CEO of Exceed Investments

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