Behavioural finance theory and structured products – in pursuit of happiness
20 August 2020
Inspired by an article written for StructuredProductReview.com by Lisa Chaudhuri (2010)1, then a vice president of Barclays Wealth, in this article, Ian Lowes, managing director of Lowes Financial Management, explores the relationship between fundamental behavioural finance theory and structured products, particularly following periods of adverse market conditions.
When studying behavioural finance, the Nobel prize winning Kahneman & Tversky (1979) 2 summarised that would-be investors will be happy when they achieve a gain, and unhappy when they make a loss – seeming somewhat obvious. Though, their Loss Aversion theory elaborates on this premise, paying attention to the idea that the feelings of jubilation when securing a gain of X% do not equate to the melancholia after suffering a loss of X%. The psychologists summarised that “losses loom larger than gains”; the pain of suffering a loss is thought to be twice as strong as the contentment of achieving an equivalent gain.
Therefore, “in the pursuit of happiness”, as observed by Chaudhuri, some investors would prefer preserving their capital in sacrifice of an otherwise larger gain – the extent of this sacrifice will depend on the individual investor and where they intend to position themselves on the risk-return trade-off. This is where structured products enter the frame.
Capital-at-risk structured products will offer investors alignment with this exact sentiment through the incorporation of a capital protection barrier, be it 70%, 60% or 50%. Assuming a European style capital protection barrier is in force, as is, and has been for some time, the market norm, investors should be comforted by the fact that even if the underlying has dropped at maturity, they will not lose capital unless it is by more than a certain percent. Or, for more risk averse investors, deposit-based plans offer capital protection from all market movements and are eligible for FSCS cover.
Naturally, defined by the risk-return trade off, the degree of protection offered by a plan will impact the returns offered; a deposit-based plan will offer a lower potential return than an otherwise identical capital-at-risk plan. Similarly, a capital-at-risk plan with a 50% protection barrier will offer a lower coupon than an otherwise identical plan with a 70% protection barrier. Likewise, entirely ‘at risk’ investments will offer higher returns than plans with an element of contingent capital protection.
For example, whilst a FTSE 100 tracker fund may offer higher, uncapped potential returns, there is no capital protection incorporated and resultantly, following Loss Aversion theory, investors may instead opt for a FTSE 100 linked structured product offering a comparatively lower maximum return, but with protection against a downturn in the index up to say, 30%.
In her article Chaudhuri refers to the period immediately after the financial crisis and “some of the most volatile markets many investors have experienced”, paying homage to the capital protection element of structured products explaining that it was under such market conditions that structured products came into their own, with investors appreciating the element of certainty and protection offered by such plans; structured product sales “soared”.
Herein lies the relevance to the whirlwind that has been 2020. As coronavirus-induced panic took grip of the world, February witnessed the worst week for stock markets since the Global Financial Crisis and in March the FTSE 100 Index suffered a 10.9% drop in a single day. Now, in August, the FTSE has picked up slightly, though it remains over 1,500 points below the level at which it started the year.
So, as fear of a second spike remains in the back of the minds of investors and analysts alike, we remind you of the importance structured products can play as part of a diversified portfolio.
In consideration of the newer, longer term autocall contracts coming to market, investors can, as we strongly encourage, ignore the daily noise of short-term volatility in the underlying and focus on the potential outcomes. Given that less than 2% of retail structures that matured between January 2010 and December 2019 returned a capital loss3, such a strategy has certainly worked. Its noteworthy that the majority of those returning a loss in that period were more exotic structures, mainly inherently risky share-linked plans, rather than simply linked to the FTSE 100 Index.
To summarise, following Loss Aversion theory, and the idea that “losses loom larger than gains”, structured products are able to offer investors a tailored ‘middle ground’ whereby positive returns are achievable, whilst still incorporating a degree of contingent capital protection. So, whilst we cannot speak for the Nobel prize winning Kahneman & Tversky, we’d like to think they would approve…
1‘The Happiness Curve’. Lisa Chaudhuri (2010).
2Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47, 263-291.
3Sourced from the StructuredProductReview.com database.
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