Putting for Par : David M Potter

A Behavioral Approach to Risk Management

“Ignorance is Strength”; so proclaimed the Party in George Orwell’s “1984” as one of their three missives.
30 years later Kahneman and Tversky published “Prospect Theory: An Analysis of Decision under Risk”.
One was science fiction and the other deeply rooted in empirical facts (some economists may argue which
is which). Yet that single message sums up one of the lessons that can be applied from Prospect Theory and
behavioral finance in general. For while asset-pricing using a behavioral framework is extremely difficult
given the lack of a robust unified model, this discipline can be very helpful on the risk-management side of
investment management.
The topic of loss aversion and risk shift has been covered widely in academic journals and popular financial
media however the events of the past year merit a more focused, practical exploration of their
consequences.

Before examining the implications for investment management let us illustrate the core idea behind loss
aversion and risk shift and how they impact decision-making and hence outcomes. In a recent working
paper1 Devin Pope and Maurice Schweitzer analyzed 1.6 million putts attempted by 188 professional
golfers on the PGA tour. After controlling for length of putts and other effects they found that loss aversion
(losses hurt more than gains help) and risk shift (risk aversion is lower when facing losses than it is when
facing gains) are both present on the PGA tour. When putting for birdies (a potential gain relative to the
reference point of par) the players were less successful than they were with par putts – the birdie puts were
hit less accurately and less hard. In other words, the golfers were trying harder to avoid a loss (missing a
par putt). Using conservative estimates the authors found that, ceteris paribus, this loss aversion and risk
shift was costing the average player more than one stroke per tournament. In dollar earnings per player this
came out to an additional $1.1 million for 2008.

The blunt implication here is that golfers’ performance would improve if they were ignorant of their score
relative to par on each hole. On a practical basis that is almost impossible barring perhaps some inhumane
short-term memory zapping device used between shots. In investment management however this goal is
more readily achievable.

Let’s use an example of a long-only portfolio manager in equities: in this case the PM’s reference point
when measuring gains and losses is not the individual price of any given stock in the portfolio but rather the
overall return of the portfolio against a predetermined benchmark. The institutional framework of the long-
only asset management industry is centered around this relative outperformance and most PMs are
compensated directly (bonus) or indirectly (AUM) on this metric. Under normal market conditions this
benchmarking may not pose an issue to the decision-making process however in the exceedingly volatile
market of the past two years the swings in such a metric on a daily basis may have been enough to
significantly skew the decision process to the detriment of returns. Checking this relative performance can
be done in real-time thanks to the advances in technology with many PMs regularly checking their status
multiple times per day. In an environment of 80% annualized volatility this may have adverse
consequences, most obviously resulting in underperforming managers altering their strategy to a more
aggressive posture (“doubling down”) to catch up while those managers outperforming may shift their risk
lower to “lock-in” some of those gains. Any level-headed investment professional would argue that
investment decisions should be made at the margin based on the merits of the particular security and not on
the current status of one’s relative performance. Yet professional active investors, like professional golfers,
are susceptible to bias and only ignorance of one’s standing will nullify that bias.

In practical terms this is difficult but not impossible. Portfolio managers should be encouraged to place far
less attention to relative performance. For a client reporting schedule on a quarterly basis this means
checking one’s performance just once at the end of each quarter. For the average portfolio manager who
might check his performance daily this would result in a two-fold beneficial effect: 1) his personal utility
from his job would rise since it is known that the “pain” factor from losses is about twice that of the
“pleasure” factor from gains and more importantly 2) the portfolio manager’s risk management would not
be affected to nearly the same degree in such volatile markets as were seen in the past year.
1
“Is Tiger Woods Loss Averse? Persistent Bias in the Face of Experience, Competition, and High Stakes”
Devin Pope and Maurice Schweitzer,The Wharton School, June 2009 Working Paper.