The Risk-Averse Investor

Daniel Kahneman became the first non-economist to win the Nobel prize in 2002.  His work in behavioural economics, in collaboration with the late Amos Tversky, provides the basis for the investment approach deployed at Conçerva.

The key insight is that most people would rather avoid losses than make gains. In other words, most people are risk-averse.

Consider the following example: would you prefer to receive a guaranteed £900 or have a 90% chance of receiving £1,000 and a 10% chance of receiving nothing?  Most people would opt for the former even though the expected outcomes are the same.

Now consider the opposite situation: would you prefer to sustain a certain loss of £900 or would you prefer to having a 90% chance of sustaining a £1,000 loss and a 10% chance of losing nothing? In this example most people would opt for the latter, even though again the expected outcomes are the same.

In the first example people prefer not to take a gamble to avoid a loss, and in the second people prefer to take a gamble in the hope of avoiding a loss.

Let’s examine this concept through the use of a real world example. Governments are keen for people to cut back on the uses of plastic bags at supermarkets for environmental reasons.  One initiative was to give shoppers a 5p bonus if they re-used their plastic bags, the effect was disappointing.  However, the imposition of a 5p levy on plastic bags was a resounding success in reducing plastic bag use.

What relevance does this insight have for Conçerva’s wealth management strategy? We know that a loss of £1,000 hurts more than the satisfaction gained from obtaining a £1,000 windfall.  So when the FTSE 100 index is falling, we aim to minimise losses; but when stock markets are rising, we accept that we might not be able to maximise gains. We do this by diversifying a proportion of your wealth out of UK equities and into fixed interest securities and overseas equities.

Brian Durrant