Perspective on global equity markets through a behavioral finance lens

Our compulsion with loss aversion

June 2016

Key takeaways:

  • Loss-aversion theory teaches us that the fear of loss can be nearly twice as powerful as the hope of earning a reward.
  • Divergent policies among major central banks and foreign-exchange volatility could have a pronounced impact on investors’ loss aversion behavior over the summer.
  • A continued low interest-rate environment over the near-term could lead to select opportunities among Energy, Technology, and Financials stocks in the U.S.
  • Focusing on the bigger picture and occasionally repressing your loss aversion instincts can sometimes be an effective strategy.

Classical finance theory espouses the notion that a natural tradeoff exists between risks and rewards, a concept clearly reflected among equity markets. For example, stocks of blue-chip companies tend to provide more moderate but stable returns over time when compared with stocks of small, newly established companies, which face a higher probability of generating outsized gains or outsized losses.

Within the broader risk/reward topic is the theory of "loss aversion," which states that investors prefer to avoid losses even more than they desire to reap rewards. Some studies have shown that the desire to avoid losses is nearly twice as powerful as the hope of earning a reward. From a behavioral finance standpoint, loss aversion theory explains why we sometimes feel compelled to make potentially unsound investment decisions at the worst possible time.

China, commodities, and credit

Loss aversion was a frequent theme in the first five months of 2016, a period that reflected concern regarding the three C’s: China, commodities, and credit. China—the world’s second-largest economy—grew at its slowest annual pace in approximately a quarter-century in 2015, with China’s stock market volatility spiking, and the renminbi sharply depreciating versus the U.S. dollar.

Emerging markets beyond China faced challenges of their own, challenges closely tied to the outlook for commodities. Demand for a country’s natural resources has traditionally provided a critical source of funding for emerging markets. Lackluster global economic growth in 2014 and 2015 correspondingly reduced the demand for a wide range of commodities, including oil.

As shown in the following chart, the price of West Texas Intermediate (WTI)—a benchmark for crude oil—fell early in 2016, sparking a global loss aversion shift as investors began looking for a potentially higher-yielding investment opportunity.

Credit concerns arose as the outlook for the Energy sector became increasingly uncertain. Many U.S. oil wells became unprofitable to drill, yet continued to drill to avoid defaulting on their outstanding debt. This exacerbated the already complex outlook for Energy companies, which have historically relied on debt financing to fund operations. In response, loss aversion tightened its grip on investor behavior, causing many business development companies, hedge funds, and private equity firms to redeploy their capital elsewhere in an effort to avoid further losses.

However, as is virtually inevitable with loss aversion behavior, sentiment eventually shifted. China’s economic data improved, the Organization of the Petroleum Exporting Countries (OPEC) discussed potential supply reductions, and credit concerns diminished. Collectively, these factors helped the markets recover, and by mid-May, both crude oil and the S&P 500 Index were higher than where they began 2016, as loss aversion behavior had reverted to more historically average levels.

For equity investors who focused on their longer-term asset allocations instead of panicking, the roller-coaster ride in equities is now probably little more than historical noise. As 2016 continues to demonstrate, market volatility does not always reflect a fundamental shift in underlying economic conditions—the U.S. economy is essentially as “healthy” now as it was in December 2015. Rather than potentially catching the wrong side of a trade, the best solution is often to ignore the noise, focus on the big picture, and on occasion, repress your loss-aversion instincts.

The best solution is often to ignore the noise, focus on the big picture, and on occasion, repress your loss aversion instincts.

Central bank divergence

As we enter into the summer months, divergent policies among major central banks seem likely to have a pronounced impact on investors’ loss aversion instincts. Since the end of quantitative easing in the U.S. in October 2014, lackluster global economic growth and a marked divergence among central bank policies has led to a difference in the real and forecast interest rates in one country versus another.

In the U.S., the Federal Reserve (the Fed) is moving toward a more "normalized" stance on interest rates, while other countries and regions are heading in the opposite direction. The People’s Bank of China has reduced reserve requirements, infused the markets with additional cash to combat liquidity concerns, and attempted to stem the flow of investment capital leaving the country. The Bank of Japan has implemented negative interest rate policies and a quantitative easing program several times the relative size of efforts formerly implemented by the Fed. In Europe, the European Central Bank has adopted negative interest rate policies designed to strengthen lending activity, while devising a plan for the region’s banks to remain profitable in spite of the challenging conditions.

However, as the Fed's early year switch to a more "dovish" tone on interest rates illustrates, steering a country or region toward economic prosperity often requires course corrections along the way. So far this year, we have experienced multiple occasions where overseas central bankers unexpectedly failed to strengthen economic stimulus efforts in spite of disappointing data. As this underscores, even central bankers are not immune to the desire for loss aversion, as they grapple with multi-billion-dollar decisions that could unintentionally cripple their economies.

Even central bankers are not immune to the desire for loss aversion, as they grapple with multi-billion-dollar decisions that could unintentionally cripple their economies.

The currency correlation

The relative value of a country's currency is directly tied in to forecast interest rates in one country versus another, which means that we could continue to experience volatility in the foreign-exchange market (where currencies trade in relation to one another) over the summer as well. The U.S. dollar appreciated significantly in anticipation of steady economic growth and rising interest rates in 2014 and 2015, returning 12.8% and 9.3% (respectively) against a trade-weighted basket of international currencies. However, the Fed’s shift to a more dovish outlook toward the start of this year reduced the support for the U.S. dollar and increased the volatility among major currencies, while pushing the U.S. dollar approximately 4.5% lower through mid-May.

In general, a weaker U.S. dollar tends to help emerging markets, particularly oil-exporting countries. Oil and many other commodities are priced in U.S. dollars to better facilitate global trading, and most emerging markets rely upon the exportation of raw goods to drive their economic growth. With the U.S. dollar generally depreciating this year, a recovery among many emerging markets has occurred, as many investors who previously decreased their emerging markets exposure have felt compelled to jump back in, as reflected in the following chart.

On the horizon

Incongruent central bank decisions, uneven economic growth around the world, and currency volatility may continue for now, paving the way for loss-aversion behavior to make further appearances over the summer. Starting in late April, the Fed seemed to shift its stance yet again, becoming more “hawkish” regarding its outlook for interest rates. This helped the U.S. dollar rebound during the second half of May, while commodities and emerging market stocks lost ground. Beyond this recent headwind for emerging markets, unresolved structural and political challenges represent longer-term performance obstacles. We also cannot ignore that approximately 40% of global gross domestic product is affected by negative interest rate policies that may not result in faster global economic growth.

If a theme of lower rates prevails in the U.S. over the near term, this could support value-driven strategies as companies downwardly adjust their risk tolerances, with loss-aversion behavior steering investors toward stable and higher-quality assets. This could lead to select opportunities among Energy, Technology, and Financials stocks in the U.S. However, any notable economic improvements could close the window on such opportunities, and lead to higher short-term interest rates in the U.S. sooner than is currently priced into the markets. With this potential backdrop in mind, focusing on your longer-term objectives and avoiding the temptation to overreact to market volatility may prove critical, as could occasionally suppressing your loss-aversion instincts.

Omar Aguilar, PhD
Chief Investment Officer, Equities
Charles Schwab Investment Management
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