The Persistence Of Aversion: Why Investor Pain Hurts Twice

by: L. Myron Clark

Asymmetry in decision-making translates into biases in behavioral economics such as loss aversion.

Selling behavior, especially at market or sentiment extremes, is not a mirror image of buying behavior.

Short-term manifestations of fear, such as equity fund outflows during January, accumulate as long-term investor underperformance.

Pleasure moves on too early / And trouble leaves too slow

- Joni Mitchell, “Down to You”

Vladimir Girshkin, the fickle protagonist of the novel The Russian Debutante's Handbook, has what author Gary Shteyngart describes a “Fear-Money gland” that leads to all sorts of misadventures. Readers who lead less storied lives may recognize the same conflicting emotions in their own investing mishaps. That’s why advisors sometimes need to intervene in clients’ glandular tendencies.

In the wealth of research by psychologists Amos Tversky and Daniel Kahneman about decision-making heuristics, one of the better-known biases is loss aversion. Their studies in prospect theory found that the pain of a loss was approximately twice as strong as the pleasure from a gain. Investor behavior demonstrates corollaries that might not emerge from a simplified laboratory experiment, as recent events reveal.

Prospect theory demonstrates asymmetry in decision-making that translates into biases in behavioral economics. These biases help explain, for example, why extreme market pessimism often marks a price reversal but optimism does not, at least not consistently. For US equities, the effect shows up in various contrary indicators such as the Investors Intelligence survey, options put/call ratios, and the Sentimentrader AIM model.

Fund flows are a more direct gauge of investor behavior, and last December provided quite a stark example. Net outflows from equity funds exceeded $90 billion over four weeks, according to Ned Davis Research. As market strategist Urban Carmel noted in a blog post, “There is no historical comparison to fund outflows seen during this period, even if the data is normalized for a larger market size.”

Loss aversion may explain why people sell into a decline if their gains on holdings are dwindling toward zero. If a position is already in the red, the fear of larger losses might draw them into the stampede. It also inhibits buying back in even though the re-rating has reduced valuation risk. As financial planner Nick Toadvine tweeted just before the final splash of December’s waterfall decline, “When the time to buy comes, you won’t want to.”

A study Charles Schwab published early last year shows that December was not anomalous, nor an American peculiarity. Over more than a decade, there was a fairly close inverse relationship between equity fund flows and longer-term global stock performance [see Figure 1].

The downside of up

The time dimension captured in the Schwab study compounds the behavioral bias. As the Joni Mitchell lyric implies, euphoria is ephemeral but pain is persistent. Following a drawdown, traders wait for a pullback (having missed the initial rebound), and long-term investors may be reluctant to rebalance or commit more funds. This effect is often visible on a shorter time scale, in both sentiment and flow-of-funds indicators. Outflows from US equity funds continued in January, according to EPFR Global data, despite a rip-roaring stock rally.

In an unusual reversal, exchange traded funds (OTC:ETFS) accounted for all the net outflows from US equity funds in January, while mutual funds saw inflows - though recovering only a fraction of their massive outflows in December [see Figure 2]. As the ETF category is dominated by large index trackers, this is a clear sign that passive investing has not conferred the buy-and-hold mentality that many industry observers thought it would.

Another twist to the January data plot was a record divergence in ETF flows between equity and income categories, according to a rolling 3-month measure of State Street fund data. This is consistent with other signs of risk aversion. It might mean, however, that the reversal of fortune for equity mutual funds vis-à-vis ETFs (shown in Figure 2) is fleeting or even misleading.

If wary investors continue buying “safe” bonds even as stocks are rebounding, both asset classes rise in price – contrary to the correlation that has prevailed most of the time during recent decades. Correlations across multiple assets approached a one-year high in January, the Wall Street Journal reported. This situation has often preceded major market turns or heightened volatility in the past. And Deutsche Bank noted increased flows into ETFs – both equity and fixed income – as volatility rose toward the end of 2018.

Regardless of how the active vs. passive contest plays out, volatility is a normal and manageable feature of investing. Each squeeze of the Fear-Money gland adds another brick in the wall of worry that a bull market proverbially climbs. But that doesn’t mean end-investors will match the bull’s pace.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.