Behavioral scientists are skilled at analyzing why we make mistakes, and financial and investment decisions have been a ripe field to till. The challenge lies in overcoming our biases that result in poor decisions, particularly in today’s late economic cycle environment with moderate economic growth, dramatic bouts of market volatility, and low long-term interest rates. Jerome Schneider, head of PIMCO’s short-term portfolio management team, and Jan Faller, portfolio risk manager, discuss in the following Q&A some key biases and share their thoughts on one area where they believe individual and institutional investors can improve: managing their cash and liquidity.
Q: Jerome, how does behavioral science apply to investing?
Schneider: Some of the most basic premises of investing are steeped in biases that are innate in human nature, and this is what makes behavioral science such a fascinating field to us. As investment managers, we could discuss dozens of biases, but among the most prevalent for investors are status quo bias, loss-aversion bias, and confirmation bias. All can be hazardous to a portfolio and to reaching investment objectives.
While we often hear about research illuminating individual biases, there is also substantial potential for institutional bias, which we certainly take steps to avoid at PIMCO. I am speaking not just to biases that can arise in disparate legacy institutions or investment frameworks, but also to a more thorough view that confirmation bias in certain areas of finance has become so ingrained that it has solidified into structural biases.
We believe the awareness of these biases and the insights that behavioral science can provide have a highly useful purpose amid current high valuations for many assets and the maturing economic expansion. As active investment managers, we should not only be aware of and address our own biases, but also consider those prevalent in the marketplace. In this way, we can be more cognizant of the biases that may limit investment performance, and by doing so we believe we can provide a valuable service to clients.
Q: Jan recently wrote a paper on loss aversion. Could you elaborate on that and the steps PIMCO takes to address it?
Faller: PIMCO incorporates behavioral finance into its investment and risk management processes – particularly the concept of loss aversion, meaning that the psychic pain of losses can lead investors to make poor risk/return decisions that put their investment objectives at risk. Daniel Kahneman, a 2002 Nobel laureate, and colleague Amos Tversky were the first to document this human bias, and Richard Thaler, a 2017 Nobel laureate, contributed to advancing our understanding of its applications.
If we were to look at a distribution curve of outcomes, the normal distribution would be misleading because the response of risk-takers to losses is far more severe than their response to gains of similar size. Kahneman and Tversky estimated a loss-aversion ratio that implies in the mind’s eye the mass of the distribution is approximately two-thirds to the left of the mean, and one-third to the right of the mean. The 2–1 relationship is a general rule that can vary by individual, the scale of the potential loss and whether or not participants are asked to “think like a trader” (in which case they become less loss-averse).
In “Look Left: Recognizing and Managing Loss‑Aversion Bias,” I explain PIMCO’s approach to this bias. To summarize here, we take steps before and after investment decisions are made. Ex ante loss-aversion management addresses potential losses in a trade or portfolio, focusing explicitly on the left side of the distribution, and asking ourselves, “How much loss can be tolerated with this trade?” We conduct stress tests, developing hypothetical forward-looking stress scenarios that represent adverse market outcomes for investment strategies. Risk budgets consider the size of possible losses in the event of an adverse scenario.
Ex post loss-aversion management entails two components of performance analysis: 1) measuring and 2) reminding. Measuring compares how a drawdown differs from expectations and can be expressed in probabilistic terms. Reminding can be more difficult. It entails looking at a portfolio and affirming that its risk profile was considered tolerable and appropriately compensated at the time of the initial investment. It may require an explicit act to overcome loss-aversion bias — bridging the gap between the forward-looking hypothetical willingness to accept a potential loss and living through a drawdown in real time.
Schneider: Within short-term portfolio management specifically, we aim to limit bias, including loss aversion, through our team-based approach. Each member of the short-term investment team brings different views and experiences – often in sectors beyond the cash and short-term management space. Along with input from our analytics group, the team approach allows us to routinely challenge market norms and adjust portfolios as needed. Our risk management group also plays an important role by asking questions of portfolio managers in an effort to improve objectivity and help discover potential biases in portfolio positioning.
In short-term investing, we aim not only to preserve clients’ capital but also to limit volatility, and we believe addressing biases like loss aversion can help us achieve both goals.
Quick Takes: Can De-Risking Portfolios Support Returns Too?
Q: Is loss aversion irrational?
Faller: Not necessarily. Losses can create difficulties that are uniquely asymmetrical to the advantages that arise from gains. Investors, for instance, may recognize the difficulty of recovering from substantial drawdowns. Numbers illustrate this point. Suppose a hypothetical portfolio of $100 declines 10% to $90. To return to parity an investor would need to earn 11%, not 10%. As further drawdowns are realized, a greater positive return must be earned to recover from the loss. A portfolio must generate a return of 100% to overcome a loss of 50%!
There are other practical concerns associated with losses that investors may intuit. Negative returns in portfolios using derivatives can create margin cash demands, which, in turn, may require sales of holdings that the portfolio manager believes are attractive and would prefer to hold. Portfolio activity motivated by loss management is certainly less pleasant than trading to realize gains. In the extreme, highly leveraged portfolios may be at risk of such severe performance drawdown that the strategy must be entirely unwound. Mandate risk – the concern that underperformance might lead to an advisor being terminated as manager of a strategy – could contribute to a loss-averse risk profile in a portfolio. All of these circumstances represent potential outcomes indicating loss-aversion bias is not irrational, and has become a structural component in many investment paradigms today.
Q: Jerome, could you provide an example of a bias you see as structural?
Schneider: A good example is the bias to considering only one choice when managing liquidity, when in fact there are many strategies that have track records in managing short-term assets. The world has more opportunities than it did during the last recessionary period, and yet investors continue to allocate to traditional money market funds and Treasury bills as a psychological default. Money market funds held more than $3 trillion at the end of March, according to Bloomberg, the highest level in about a decade – and back then, investors were putting money in these funds in the wake of the global financial crisis.
Investors have likely flocked to money market funds more recently because of the desire to hold liquidity this late in the economic cycle amid dramatic bouts of market volatility, as we have seen over the past six to 12 months. Because of structural biases, the status quo bias (a preference for things as they are), and loss-aversion bias, investors are likely to remain in those funds beyond their original intention and miss out on potential opportunities for higher returns as they develop. We have found that investors’ desire for same-day liquidity is often much greater than their actual need for same-day liquidity.
Q: What are your suggestions for overcoming bias when it comes to cash and short-term investing?
Schneider: We encourage all investors to consider if they are operating under any behavioral bias – it’s good practice to periodically review one’s motives, since often we are not aware of the biases that color our thoughts and actions. PIMCO certainly takes steps to address its biases, as Jan discussed, and indeed doing so is one of the key responsibilities and values that active managers should bring to the table.
When it comes to portfolio liquidity, we appreciate that vehicles such as money market funds can be appealing to invest one’s cash and wait out market turbulence. However, investors may want to consider that the return on these funds generally comes mainly from yield − often below benchmark rates − rather than from a combination of yield and capital appreciation, and also that both the loss-aversion and status quo biases can result in leaving assets in such vehicles for long periods.
We believe it is critical for investors to approach cash and short-term investments as a true structural allocation instead of an afterthought or default reaction. This process begins with considering how much liquidity is actually needed over various horizons and how much risk an investor can tolerate. We generally divide an investor’s liquidity requirements into three tiers over a temporal horizon. Tier 1 is immediate or daily cash needs. Tier 2 is intermediate needs, over the next few months or quarters. Tier 3 is longer-term needs, over the next few years. Actively managed short-term strategies (Tier 2 and 3), which aim for returns higher than traditional cash investments, can add attractive risk-adjusted return potential with this type of active liquidity management tiering.
Tiering liquidity can enable investors to target assets that best match a given investment horizon and risk tolerance, and help investors overcome the status quo and structural biases that could be detrimental to their investment goals.
The PIMCO Decision Research Laboratories at the University of Chicago Booth School of Business Center for Decision Research enable academics to conduct the highest impact behavioral science experiments where people live and work. Through this innovative partnership with the University of Chicago, PIMCO supports diverse and robust research that contributes to a deeper understanding of human behavior and decision-making and helps empower leaders to make wiser choices in business and society.
Learn more about behavioral science at PIMCO.
For more on earning income and de-risking with short-term strategies, please see “Quick Takes: Can De-Risking Portfolios Support Returns Too?”