Summary

Successful investing is often as much about managing emotions as capital. You can take care of your own mental ups and downs, but how do you address those of your clients? First, you need to set a baseline for expected returns and the volatility associated with those results. Then, you need effective risk management tools – ones your investors understand and agree to – to incorporate into your process. Finally, you need a playbook for understanding investor psychology. There’s only one model for human behavior to win a Nobel Prize – Daniel Kahneman’s Prospect Theory – and that is the one to use.

You should choose the latter, since its expected value is $1,250 (50:50 odds on zero or $2,500). But how would you feel if you gave up an easy grand if you lost the coin toss? Pretty stupid, right?

When we ask this question of groups of hedge fund managers and other investment professionals at conferences and meetings, the overwhelming answer is to go for the sure $1,000. These are groups that can do the math – they know they are leaving money on the table. But these are groups that know the power of regret – perhaps more than the general population. So they choose the sure money.

The asymmetry of human emotions over financial gains and losses is actually a relatively new field of academic analysis. For years, economic models assumed that all humans would choose the coin flip since it is the mathematically superior option. It was only in the late 1970s that two researchers – Amos Tversky and Daniel Kahneman – outlined how humans actually make decisions under uncertainty with their landmark paper “Prospect Theory: An Analysis of Decision under Risk.”

Kahneman ended up winning the Nobel Prize in Economics for his work in 2002, and the lessons of Prospect Theory are important to keep in mind:

• Losses weigh more heavily than gains on the human psyche. Losing that $1,000 sure thing in the example above feels worse than the chance of making $2,500 OR the expected value of the coin flip.

• Humans use a variety of mental shortcuts to assess risk and return. How you frame a question about potential outcomes can sway decision-making. For example, would you prefer an investment that has an average 7.5% return, or one that varies wildly between 0% and 15%? Both may generate the same long term result, but the first seems more like a “sure thing.”

• Classic economics, with its emphasis on profit-and-utility maximizing human agents, is flat out wrong. All this is deeply relevant to the professional investor managing outside capital. Not only do you have your emotions to consider, but those of your investors. Through the lens of Prospect Theory, we know that both are non-linear and weighted to feel the pain of losses much more than the prospect of gains.

• Communicate the risk-reward relationship of your investment approach as clearly as possible. Some investors use Value-at-Risk on real portfolios, others prefer Monte Carlo analyses of worstcase scenarios. Our advice: use them all. The better investors understand the risk parameters of your approach before they invest, the fewer questions afterwards.

• Manage to a consistent risk profile. This can be as simple as blanket stop-loss rules for individual names or as complex as cross-correlation analysis and dynamic portfolio stress testing. But whatever it is, stick to it.

• Frame all discussions of performance in the context of risk management. It is all too easy to focus on the wins, but how you avoid losses is also important to investors. And when you have drawdowns, explain those in the context of pre-existing risk parameters as well.

The most important points here are straightforward: human emotions add a layer of complexity to the investment process that you need to acknowledge in your analysis and communications. Every investor, no matter how good, will have down quarters and even years. The right time to explain your risk management process is before those occur, not after.
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