Basic prospect theory is something that every professional in finance should be familiar with. At the very least, if you don’t find it interesting, you’ve chosen the wrong career. The main claim is that our willingness to assume risk changes depending on the scenario. For example, when given a choice between a free $25 or a 50/50 chance to win $60 or $0 the optimal choice is to take the coin flip with an expected payout of $30. But many people will choose the safe $25. You probably find yourself agreeing with the $25 decision and you right now, and you might think I’m nuts. We call this “risk aversion”. But put into a context where the player can play this game multiple times, she’s more likely to take the risk. Over the course of a lifetime, these seemingly unique opportunities will present themselves multiple times, and avoiding these good bets can take its toll.
Counter-intuitively, when faced with the decision between a free $25 or a one-in-a-million chance of winning $5 million (the expected outcome of which is only $5), many people will choose the lottery ticket. Not me (I hope).
Even more counter-intuitively, when people are facing risk in the realm of losses, we tend to be risk seeking. For example, given a choice between paying a $25 ticket, or fighting the ticket with a 50% chance of paying nothing or a 50% chance of paying a fine and legal fees totaling $100, the best choice is to just swallow the $25 loss. The expected outcome of fighting the ticket is a loss of $50. But many people will foolishly roll the dice.
These preferences, despite being sub-optimal, are well documented by behavioral economists. Every year we’re discovering new ways in which people systematically make poor decisions.
TIPS
At Kerrisdale, I recently published a short write-up comparing Treasury Inflation Protected Securities (TIPS) to regular treasuries. What I found interesting was that investors seem to be terrified of inflation, but the spread between TIPS and treasuries only implies 2% annual inflation over the next 10 years.
I believe this disparity exists because the short-term nominal yield on TIPS is negative. The chart below shows the yield on 2-year
TIPS (in green) is a negative 0.5%. The thought of
locking in a loss is undoubtedly distasteful to investors, despite the fact
that individuals holding treasuries, CD’s or even cash are likely going to
experience a loss of purchasing power anyway.
So the questions become:
1) What investments are you holding in your portfolio because of inflation fears, and is there a better way of managing that inflation risk?
2) If you fear 30% inflation over the next 5 years, doesn’t a 30% nominal yield on treasuries sound more attractive than rolling the dice on some other “inflation hedge” that may or may not appreciate in value and might result in significant losses?
3) Can you reconcile the 2% inflation expectation implied by the TIPS spread with the price you’re willing to pay for your “inflation hedge” (ie gold)?
