The Long Run Quarterly Letter: October 2010

"Man’s cleverness is almost indefinite, and stretches like an elastic band, but human nature is like an iron ring." -H. Rider Haggard

Most proponents of efficient market theory assume that investors are rational and in conscious control of their major decisions. The investor whole absorbs and calculates all factors and potentials and arrives at a highly accurate conclusion: The market price for a given asset. Starting with John Nash’s 1994 Nobel Prize for his study of game theories and recently supported by Daniel Kahneman’s 2002 Nobel Prize award for his integrated insights from psychological research into economic science, behavioral economists now argue effectively that market participants are often not rational and, in many cases, are unaware of the forces that dictate their behavior.

The phenomenon of loss aversion refers to our predisposition to strongly prefer avoiding losses over acquiring gains. In fact, a large body of studies suggests that losses are more than twice as psychologically powerful as gains.

One way to look at the phenomenon is to uncover whether it is learned behavior or biologically hard-wired into us. At Yale, Laurie Santos has been teaching capuchin monkeys basic economic skills to determine if there are deeper roots underneath our bad decision-making. Capuchins are well-suited subjects for study since they are relatively large-brained primates, skilled problem solvers, and a close evolutionary neighbor to humans. In these studies, monkeys were given a budget of disks and asked to decide how much to spend on apples, and how much to spend on the gelatin cubes, even as the prices of these goods and the size of their budgets fluctuated. Capuchins performed much like humans do. They, like humans, reacted rationally to these fluctuations.

In a second experiment, capuchins were asked to choose between spending a token on one visible piece of food that, half of the time, gave a return of two pieces, and two pieces of visible food that, half the time, gave a return of only one piece. Economic theory predicts that consumers should not care which of these outcomes they receive since they are essentially both 50-50 shots at one or two pieces of food. The capuchins, however, vastly preferred the first gamble, which is essentially a half chance at a bonus, than the second gamble, which is essentially a half chance at a loss.

Another way to understand how powerful loss aversion might be is to see if identical outcomes framed differently create different human responses. In a 1984 study, Kahneman did just that. A representative sample of physicians was told that the U.S. needed to prepare for an outbreak of an unusual Asian disease which was expected to kill 600 people, and then given the following choice: If Option 1 is adopted, 200 people would be saved; if Option 2 is adopted, there is a one-third probability that 600 people would be saved and a two-thirds probability that no people would be saved. Comforted by the knowledge that they would assuredly save 200 people, 72% of these physicians chose Option 1. A second group of representative physicians was confronted with the same dilemma, but the choice was framed differently: If Option 1 is adopted, 400 people will die; if Option 2 is adopted, there is a one-third probability that nobody will die and a two-thirds probability that 600 people will die. Offered the same outcomes in a different frame, only 22% of the second physician group chose Option 1, and 78%, enticed by the potential of avoiding any loss, chose the riskier Option 2 – a near perfect reversal.

Why the lesson on loss aversion? Since the brutal downturn of 2008, investors have been conditioned to look to the downside. Headlines blare out the potential for us to sink back into a depression. We are reminded of 1937. Book titles warn us of potentially devastating “Fault Lines” and worse. Within the last two weeks, John Paulson, a hedge fund manager who famously made billions on his bet against subprime, told three roomfuls of investors that inflation would reach double-digits by 2012 and to buy gold and houses. Within 24 hours, John Lekas, senior portfolio manager at Leader Capital, warned that we faced severe and imminent deflationary pressures that would knock the Dow Jones Industrial Average down to 4200 by the middle of 2011, lift the “real” unemployment rate to 24% and force housing prices down another 20%.

Of course, we live in an accident-prone world where there is clearly potential for significant dislocations on many fronts. That is why any reasonable portfolio contains protections against inflation and deflation and against periods of illiquidity in the markets. Loss aversion in today’s collective investment psyche, however, has transformed hedging positions that historically have played a complementary role in portfolios into dominant core holdings for many retail investors. These investors are betting big on narrowly defined risks with large negative outcomes. Just as the physicians took on greater risks in order to avoid loss in the Kahneman studies, many investors have made significant binary bets on inflation or deflation or the collapse of the dollar which may prove to be 100% right . . . or 100% wrong.

Just as retail investors paid any price for the promise of participation in "new paradigm" in the late 1990s, they are today paying exorbitant prices to avoid their chosen tail risk in the face of terrifying potential dislocations. On the backs of demand from retail investors for inflation protection, precious metal ETFs have ballooned from zero to more than 100 billion dollars in value in just seven years – and investment houses are scrambling to create more products to feed widening demand. More than half a trillion dollars has crushed into fixed-income funds over the last two years as investors have sought durable yield against vexing Japan-style deflation. In both cases, retail investors have been flooding out of equity assets trading at historically low valuations and crowding into assets trading at historic highs in the name of safety. Many investors are clearly falling into the classic trap of selling low and buying high. Warren Buffet put it more succinctly recently when he said that investors rushing to the perceived safety of bonds are "making a mistake."

There is, indeed, a “new normal” that is likely to exert itself. We expect a long period of slow growth in the face of necessary deleveraging and rebalancing. We are witnessing the breakdown of coordination in global policy and recognize that currency controls and rising protectionism will sand the gears of economic expansion. And yet, there are significant growth opportunities available at reasonable prices in the market – the upside of current loss aversion tendencies, we suppose. Many growth stories are not tethered to the pace of global GDP growth and are driven by compelling independent factors. Labcorp, as an example, enjoys widening demand for a broader and broader array of lab tests as genomic inputs advance and a larger portion of the population seeks out preventive and regular lab tests. Cree is riding the early stages of a boom in LED adoption in a market that is expected to grow by more than 100% next year. Novozymes leads the enzyme business which continues to find new markets in which to replace chemicals. To complement these and other core growth holdings, we continue to maintain diversified currency exposures and to hold cash, a short ladder of high-quality bonds and operating companies in commodity-related businesses where there is underlying functional demand for the commodity.

In a complicated and ever-changing world, balance should not be overlooked as a critical core tenet of a sustainable investment discipline.