Loss-aversion bias

CFA Level III Portfolio Management
#1

Question 6 of reading 6 on behavioral biases.

[question removed by moderator]

The answer is observation 3. It says that “loss aversion by itself may cause a sector concentration, however, a market neutral strategy tends to focus on individual stocks without regard to the sector. The sector exposure would be mitigated with the balancing of the individual long and short positions”.

I can understand that.

But I could have equally considered observation 2 to be the right answer.

The curriculum states " Loss aversion leads people to hold their losers even if an investment has little or no chance of going back up. Similarly, loss-aversion bias leads to risk avoidance when people evaluate a potential gain." So they trade less on the stocks that are losers and more on the stocks that are winners. All in all it does not seem that they trade less. If, overall, the market was in a down trend, then maybe they would trade less. But here there is no such indication + the fund has a long short strategy.

#2

“consequence” is the key word.

#3

question is asking which observation is least likely.

  1. Obs 1 - positions under water - higher risk profile still held on portfolio - would be supported by loss aversion. Since they refuse to sell.

  2. Obs 2 - trading volume decreased by more than 40% is also equally possible - they refuse to sell.

however obs 3 - portfolio concentration is FEWER sectors than in the past - is not likely. given they have built up what they like and what they don’t - they would end up selling more … so there would be MORE sector concetration…

does that make sense?

the fund has a market neutral strategy – not long short too…

#4

I tried to focus another time on it. I thought maybe I missed the “least likely” (i am tired). But no, I would have thought that it is not likely that trading volume has decreased as a result of loss aversion. I think it could happen, but it could also increase, or remain stable, depending on the market performance (see my comments above for more details on my arguments on this).

And yes, the strategy is long short. That’s generally the case of a market neutral strategy, and that’s given in the question anyway.

#5

And again, my question is not “why observation 3”?. I understand that one. My question is “why wouldn’t observation 2 work as an answer as well?”

#6

According to the curriculum (please refer to the extract of the curriculum I quoted in my first post above), loss-aversion leads to:

  1. less trading on loss positions

  2. more trading on gain positions

than if the portfolio manager was perfectly rational.

I am thinking that, probably, the assumption is that loss aversion is more about 1) than about 2). Then all in all, it would lead to less trading than in the case of perfect rationality. And that would explain that “observation 2” cannot be the answer to the question. That’s the only explanation I can come up with.

#7

I’ve thought through this and have a couple points:

(1) While loss aversion has implications for both losing positions and winning positions, most of the questions on this topic I have seen tend to focus on the losing positions. As such, this question could just be taking that for granted.

(2) Secondly, it could also be a matter of degree. Remember, the question isn’t asking for an absolute right or wrong, but simply which of the three is the least likely. Choice #1 is obvious enough and doesn’t warrant discussion (sounds like a near 100% chance of being indicative of loss aversion). Choice #2 is at least possible to be a sign of loss aversion, but as you said, gains could also lead to more trading. As such, let’s handicap this one at a 50% chance of being indicative of loss aversion. Choice #3 I suppose could be indicative of loss aversion, but I can’t really explain why. As such, I wouldn’t even be able to call this one 50/50. I’d call it something less than 50% and something greater than or equal to 0%.

Given my probabilities, #3 is least likely. You have to continually be thinking about the relative nature of many of these questions. It’s not asking “Which is loss aversion and which isn’t loss aversion.” It’s asking which is least likely to be loss aversion. Consider if he has all losses - them choice 2 definitely starts sounding like loss aversion because he’d definitely be trading less. I can’t think of a loss aversion scenario where choice 3 would definitely be true.

#8

Here is my understanding why #2 is 100% correct. The trading volume for long/short market neutral strategy in case of loss aversion will go down no matter in which direction the market is trending. The manager will keep not only losing long positions but also short positions. As for profiting trades he will probably exit them much earlier but opportunities to trade will not present more often because of his actions, so trading volume will not increase.