Since the 18th century economic theory was built on the foundation that humans assessed losses and gains equally. It has only been in the last 50 years or so that behavioural economists and psychologists have proven this is not the case.
This fundamental flaw in economic theory has been exposed because:
Behavioural economist Richard Thaler and psychologist Daniel Kahneman have both been awarded Nobel prizes for their research into the behaviour and decision making processes of humans and the role of these processes in understanding the broader field of economics. Understanding their findings about reference points, loss aversion and regret can help the investment industry counsel their clients through the most turbulent market in history.
Importance of a reference point
To highlight the importance of a reference point Kahneman, in Thinking, Fast and Slow, uses the following example. He uses the monikers Anthony and Betty.
Anthony currently has $1 million, Betty $4 million. They are both offered a choice between a gamble and sure thing. The gamble would leave them with either $1 million or $4 million. Doing nothing and accepting the sure thing is to own $2 million. The theories that underpin most economic principles assume Anthony and Betty will make the same choice because the theory does not consider the reference points that Anthony and Betty will consider when making their judgements.
Anthony who currently has $1 million will double his wealth with the sure thing. This is attractive. Alternatively, he can gamble with equal chances to quadruple his wealth or gain nothing. That’s risky. Betty, on the other hand, will almost certainly baulk at the certain $2 million outcome because that means she will lose half her wealth. Alternatively, she can gamble and lose three quarters or retain her $4 million. You can see that Anthony and Betty are going to make different choices.
The reference points, make the ‘sure’ outcome good for Anthony and bad for Betty.
You’ll note, Betty, faced with a loss becomes a risk seeker. This underpins Prospect Theory, people seek risk when all the options are bad. It sounds counterintuitive but it’s true.
Prospect Theory or the human response to losses is stronger than to gains
Consider these two problems (again, these are summarised from Thinking, Fast and Slow)
1 – You have been given $1,000?
You are now asked to choose one of these options:
50% chance to win $1,000 OR get $500 for sure
2 – You have been given $2,000?
You are now asked to choose one of these options:
50% chance to lose $1,000 OR lose $500 for sure
The ‘sure’ outcome to both problems is $1,500. Most people are risk averse in problem 1 and accept the sure $500. However in problem two, they are more likely to gamble, even though the probability is high that they will lose $1,000 not $500.
What researchers discovered was that, when weighed against each other, losses loom larger than gains and humans will do all they can to avoid losses. This a principle of Prospect Theory. According to Kahneman this process has an evolutionary history, “Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.” This might have helped us in the wild, but its results in the investment world vary. Investors must evaluate and assess start-ups, company results and future prospects each with uncertain outcomes.
The options investors face every day involve a risk of loss and an opportunity for gain. We generally do not like to accept the risk of losses For example, Behartzi and Thaler (1995), pondered why individual investors continued to shun stocks even though their real returns had been about 7% per year since 1926. They attempted to determine what ‘premium’ people would accept to consider this higher returning option, which could incur short-term periods of losses. Behartzi and Thaler found individual investors were “unwilling to accept return variability even if the short-run returns have no effect on immediate consumption.”
Behartzi and Thaler made reference to ‘organisations’, to test if they too were loss averse. They found pension and endowment funds were also susceptible to loss aversion, but that they were however were more likely to have significant exposure to growth assets given the long term nature of their investment objectives.
Of course, back in 1995 when Behartzi and Thaler wrote their paper, many people were not yet exposed to long term investing for pensions. The superannuation guarantee had only been introduced in Australia three years prior. Since then share ownership has increased. Australian investors, via their superannuation which is restricted from immediate consumption, have become more comfortable with the volatility that comes with stock market investing.
Given this increased level of comfort to save for the long term in their super, we wonder if Behartzi and Thaler did their research today in Australia, would they find a change in the level of risk aversion?
What Behatzi and Thaler’s models, as well as Prospect Theory, fail to allow is disappointment and regret.
That feeling of regret
Regret has been defined as “the pain we feel when we realise that we would be better off today if we had taken a different action in the past.” When you are investing you are exposed to possible future regret and people take this into consideration when they decide to allocate their money to an investment. This can lead to a process that behavioural economists call ‘narrow framing’. Barberis, Huang and Thaler (2006) found that narrow framing is a more important feature on decision making than previously realised especially when the outcome could lead to regret. Narrow framing is the process of using information that most accessible. For example, it is natural in the current market environment, to consider short-term returns. Unfortunately losses occur more often in risky assets when short term returns are considered, and for investors allocating to these risky asset classes this could lead to potential regret should losses occur and the gamble turns out poorly.
Alternatively, the regret could be missing out on gains.
This is where information filtering is paramount. Daily exposure to newspapers, books and online media with information about stock markets and bonds is accessible to everyone. In Australia, all working Australians are investors through the superannuation guarantee and their superannuation funds. We think over time this will continue to lead to superior decision making and active participation in markets by all Australians.
It’s important to look past the positive and negative commentary and concentrate on long term goals. Successful long-term investors survive short-term falls by sticking to investment principles that have withstood the tests of time. For portfolios, this may include better diversification. For equities, investing in profitable companies with strong balance sheets and stable earnings has historically given resilience to portfolios.
It’s interesting to note, in Thinking, Fast and Slow, when participants in Kahneman’s experiments are “instructed to ‘think like a trader,’ they become less loss averse and their emotional reaction to losses (measured by physiological index of emotional arousal) was sharply reduced.”
Barberis, Nicholas; Heung, Ming; Thaler, Richard H. (2006). “Individual preferences, monetary gambles, and stock market participation: a case for narrow framing”. American Economic Review. 96 (4): 1069–1090
Benartzi, Shlomo; Thaler, Richard (1995). “Myopic loss aversion and the Equity Premium Puzzle”. The Quarterly Journal of Economics. 110 (1): 453–458
Kahneman, D. (2011) Thinking, Fast and Slow, United States, Farrar, Straus and Giroux
Compounding is an extremely effective investing tool, says Morningstar Investment Management’s Head of Institutional Portfolio Management and Solutions, Jody Fitzgerald, but it’s important to be aware of its inverse power on the downside.
The plea for a taxpayer-funded bailout from mismanaged industry super funds is compelling evidence that workers should be allowed to keep more, not less, of their hard-earned money.
· 12:00AM APRIL 1, 2020
Many people are recycling Warren Buffett’s famous quote that it’s only when the tide goes out that we discover who has been swimming naked. And for good reason: one Australian industry is looking pretty ugly right now, its mismanagement and hubris exposed by this current crisis. The naked swimmers are the trustees of the biggest industry superannuation funds and their directors.
This sector rode so high and mighty in the good times that it demanded that the corporate sector, especially the banks, take money from their owners and give it to causes deemed worthy by these industry super funds.
In the midst of this crisis, while the banks are honourably bailing out their customers, these sanctimonious industry super funds demand that ordinary Australians rescue them and their members from the consequences of the sector’s arrogance.
The biggest question is how this group has been protected from scrutiny and sensible regulation for so long, and what can be done to end its immunity from the kind of critical examination the rest of the financial sector has always faced.
Consider the causes of the arrogance and power of large industry super funds. They have been coddled by an industrial relations club that mandates that it be showered with never-ending torrents of new money. Of the 530 super funds listed in modern industrial awards, 96.6 per cent are industry super funds. That’s some gravy train.
With that guaranteed inflow of cash, it’s hardly surprising that industry super funds have grown fat and lazy about risk. They made two critical assumptions. First, that these vast inflows would always exceed the outflows they had to pay pensioners and superannuants. And second, they could keep less of their assets in cash or liquid assets to meet redemptions.
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In fact, they doubled down on this bet by plunging members’ money into illiquid assets — they filled their portfolios with infrastructure, real estate, private equity and other forms of long-term assets that can’t be easily and quickly sold to meet redemptions.
These assets can’t be easily valued either — experts will tell you that the valuation of illiquid assets is essentially guesswork. If you don’t have a deep and liquid market into which to sell an asset, you really have no idea what that asset would fetch if and when the time came to sell.
The fact the valuation of illiquid assets is open to huge variation was a terrific advantage in so many ways for industry insiders during the good times.
Industry super funds could use boomtime assumptions to produce inflated valuations to prop up their performance relative to retail funds that don’t have the same guaranteed gravy train of inflows to invest in unlisted long-term asset classes.
That gives the industry funds one heck of a competitive edge and those inflated performance figures make for handsome bonuses for employees of industry funds and asset managers such as IFM.
This apparent outperformance by industry super funds seems to have anaesthetised the Australian Prudential Regulation Authority and many others. They have been able to resist sensible regulation by pointing to their “healthy” performance, and they have received exemptions from the kind of stock-standard rules that govern other trustees of public money.
The upshot is that many industry super funds have ridiculously large boards stuffed full of union or industry association nominees who obligingly pass their directors’ fees back to their nominating union (where, lo and behold, it might find its way to the ALP) or industry association.
But now the music has stopped. What these big industry funds have sold to members as “balanced” funds doesn’t look so balanced any more.
The current crisis has exposed illiquidity issues. Many of their members have lost their jobs or lost hours of work, drying up the guaranteed flow of new superannuation contributions.
And the Morrison government has announced an emergency and temporary exemption allowing members in financial trouble to withdraw up to $10,000 a year from superannuation for each of the next two years.
The liquidity problem facing industry super funds has been compounded by the fact many members have been switching from what the industry funds call “balanced” options into cash options, requiring funds to liquidate long-term assets in the “balanced” options.
This new environment has forced industry funds to slash questionable valuations of illiquid assets in their “balanced” funds to avoid redeeming members or members who switch out of balanced funds into cash options getting a windfall at the expense of members who remain in the “balanced” funds.
So the jig is up. When comparisons between industry super funds and retail funds are adjusted for risk — as they should be — industry super funds don’t look so healthy after all.
Now that the tide has gone out, we can see two issues with greater clarity. First, trustees of industry super funds haven’t done a stellar job of managing risk through the full economic cycle, through good times and bad.
There was too much complacency from more than two decades of uninterrupted economic growth. And maybe some naivety too: Australian industry funds are relatively new, emerging only in the 1980s after the introduction of compulsory superannuation payments.
Second, APRA stands condemned for letting industry super funds get away with second-rate governance and poor management of risk through the full economic cycle.
Consider the hypocrisy of these super funds now wanting a bailout to deal with a liquidity problem of their own making during the boom times. For years, noisy industry funds have sanctimoniously demanded that company boards give up some profit to benefit society.
Now their mismanagement has exposed risks that their members may not have been told about. And the same industry funds want the Reserve Bank of Australia (aka the taxpayer) to bail out their members to protect their boards from claims of mismanagement. The industry funds no doubt will point to the help the government is giving the banks as a precedent for a bailout.
However, they should remember that the quid pro quo for banks getting government help is the banks meeting a stringent set of capital and liquidity rules, not to mention governance requirements such as a majority of independent directors. Do these funds want a similar regime instead of the namby-pamby one that applies now?
To date, and to its credit, the Morrison government has resisted their calls. Scott Morrison and Josh Frydenberg should stand even stronger, demanding APRA lift its game. How did the industry fund sector escape scrutiny of its dirty little secrets for so long?
Part of the reason is sheer thuggery. Industry Super Australia, the representative body for industry super funds, tried to silence Andrew Bragg a few years ago when he was at the Business Council of Australia for exposing the unholy links between unions and industry fund. Bragg, now a senator, is leading the push to reform industry super.
The voting power, and buying power, of huge industry funds is another part of the answer. Their special pleading and scare tactics to ensure they can keep feasting on members’ funds by having the super guarantee charge contribution increased from 9.5 per cent to 12 per cent is the rest of the answer.
The pathetic plea for a taxpayer-funded bailout from mismanaged industry super funds is compelling evidence that workers should be allowed to keep more, not less, of their hard-earned money rather than be forced to shovel more into industry funds and their mates.
Janet Albrechtsen is an opinion columnist with The Australian. She has worked as a solicitor in commercial law, and attained a Doctorate of Juridical Studies from the University of Sydney.
The following article was written by Chris Brycki on the 27th of March 2020. And given his credentials, I would recommend your review. He sits on two Advisory Committees for the industry regulator ASIC and was previously a fund manager at UBS. He holds a Bachelor of Commerce (Accounting/Finance Co-op Scholarship) from UNSW.
It reflects what we have been saying for the past 5 years and we are extremely concerned that some Industry Funds could lose anywhere from 50%-70% of value over the coming months.
The issue may not be performance-based, however negatively compounded as members are locked out from redeeming their benefit (accumulation or pension) or being able for it to be invested accordingly toward any future growth over an unknown future.
Although the following report focuses mainly on Hostplus who is in a particularly compromising position, several other major Industry Super Funds will also significantly be affected due to their extremely large exposure to Unlisted Assets, Venture Capital and Private Equity.
From trade wars to Brexit, and now the dramatic implications of coronavirus, we’ve had plenty to deal with. So, what do we mean by “staying the course”? It’s not always about sitting still, but rather, to focus on the goal that you set in the first place and ensure your behaviours align with it.
With all the hoo-ha around in the media at the moment around fear and hysteria from the COVID-19, Tony and Jamie discuss our position with our portfolio and the drawdowns on them.
They also touch on the hot topics about the irrational behaviour from the public in regards to the erraticness within supermarkets.
The ATO has put taxpayers on notice that it will be increasing its attention towards any undeclared foreign income, and has indicated it will contact those taxpayers where they have information from a foreign revenue authority or other third parties that they may have received income from another country.
Taxpayers who are residents of Australia are required to include income from all sources in their annual income tax returns (undeclared foreign income). For Australians working in other countries, the recent decision in Harding v Commissioner of Taxation  FCAFC 29 concerned the definition of “resident” and “resident of Australia” in our income tax law and its application to individuals.
In this decision, a person is not only a resident if they reside in Australia but includes a person whose domicile is in Australia and who does not have a “permanent place of abode” outside Australia.