Blog: Samuelson’s bet, myopic risk aversion and the banking conundrum
“Would you like to take this bet?,” asked Paul Samuelson to one of his colleagues—a 50% chance of winning USD200 or losing USD100 (inflation adjusted bet of cUSD1,700 now). The colleague politely turned down the offer but indicated that he would be happy to play the game 100 times, if he did not have to watch each individual outcome.
If that sounds like an obvious answer, do consider this happened in 1963. Back then, the modern portfolio theory rested on the assumption of rationality. The utility theory, popularised by John von Neumann and Oskar Morgenstern, was the accepted dogma on how individuals made economic decisions (how alternatives are presented is not as pertinent as much as the conclusion of what is best for oneself).
That started changing in 1968, when Daniel Kahneman invited Amos Tversky to a lecture at one of his seminars. It was the beginning of a partnership that would last for almost three decades (until Tversky died in 1996) and one that would redefine economics altogether in its wake. In 2002, the Nobel Prize in Economics was shared by Vernon Smith and Daniel Kahneman—a remarkable achievement for both men, but especially for Kahneman. For, you see, Kahneman is not an economist, he is a psychologist.
Kahneman’s and Tversky’s work on ‘judgement under uncertainty’ and ‘decision-making under risk’ brought out what we now consider customary behavioural finance terms—anchoring, framing, mental accounting, overconfidence and overreaction bias. They were able to mathematically prove that individuals regret losses more than they welcome gains of the exact same quantum (by a factor of 2x—losses cause twice the pain compared to pleasures from gains); a stunning revelation.
This study was taken forward by Richard Thaler (now a professor at Chicago Booth School), along with his co-writer Shlomo Benartzi (now a professor at UCLA Anderson School of Management). Samuelson’s colleague was willing to accept the wager with two qualifiers: (a) lengthen the time horizon; and (b) reduce the frequency of watching outcomes. Using these, Thaler and Benartzi coined myopic risk aversion.
They examined the return, standard deviation and positive return probability for stock with time horizons of 1 hour, 1 day, 1 week, 1 month, 1 year, 10 years and 100 years, and applied a utility function of loss aversion factor of 2. The outcome: the utility function did not cross over to a positive number until 1-year holding period—i.e., frequency of evaluation of returns more often than once per year causes more pain than pleasure. Clearly, investors are less attracted to high-risk investments like stocks when they evaluate their portfolios over shorter time horizons. ‘Loss aversion is a fact of life. In contrast, the frequency of evaluation is a policy choice that presumably can be altered.’
Had one taken Thaler’s and Benartzi’s advice seriously, and not looked at one’s equity portfolio since the start of the year, the person would have not felt the pain of the 30% draw down in Nifty, which has nearly completely retraced. The banking sector is another story, however. Rebased as of 1st February 2020, the Nifty Bank Index had under performed the Nifty Index by 8.5% through 23rd March 2020 (when Nifty Index hit a bottom). As of 30th June 2020, the under performance had increased to 16.7%, and as of writing this (26th August 2020), it has increased further to 20.9%. How domestic equity mutual funds are positioned is even more interesting!
As of the quarter ending June 2020, the domestic equity mutual fund industry’s exposure to the banking sector (including diversified financials) stood at 29.6%—lowest in the past five years. Between December 2019 and June 2020, mutual funds reduced their exposure by c8.1%. Evidently, some of it will be driven by the relative under performance of the sector itself. Nevertheless, mutual funds went from an overweight stance of 0.7% in December 2018 to an underweight stance of 2% in June 2020.
A large part of the aversion to the banking sector comes from the fact that it is a leveraged business. A small reduction in value of assets can lead to a larger change in book values. And, at a time when a few customers are not paying their installments (due to loan moratorium), the aversion is understandable as well. Nevertheless, one wonders if this is another case of a ‘myopic loss aversion’ from seasoned investors (please see table below).
Source: ACE Equity, Buoyant Capital calculations
For one, the current dip in Bank Nifty is the steepest relative under performance witnessed on record (data since 2000; (absolute dip in Bank Nifty was steeper during the Global Financial Crisis). One could argue that the banking system in India is yet to encounter a steeper challenge than the one posed by the Covid-19 crisis. This despite it witnessing the massive Global Financial Crisis in 2008, rising NPA cycle in 2015, demonetisation in 2016 and the NBFC crisis in 2018.
What’s clear, however, is that, historically, it has always been the case of myopic loss aversion for markets whenever a crisis appears. For example, from March 2006, the Bank Nifty under performed for three months by 12.4%, but returned 165.9% over the next 19 months, outperforming the Nifty 69.7%. The rest of the data in the above table must be read accordingly.
Now that we are in the midst of the highest relative under performance ever seen in the banking sector, only time will tell whether it is the case of another ‘myopic loss aversion’ by investors or ‘this time, it’s really different!’