Tuesday, May 12, 2015

Loss aversion, investor behavior, and fees



One of the key behavioral biases we face is loss aversion. The pain of losses is much greater than the pleasure from gains. Economist have been doing a good job of trying to form laboratory experiments with controlled subjects to measure these behaviors. A recent paper in the American Economic Journal: Microeconomics provides strong experimental evidence on loss aversion through consumer choice between sandwiches. 

This seems like a good real life situation. The subjects have a choice between two different sandwiches. There may be clear taste differences. The question is how much you will pay for the sandwiches when you do not know their prices, or how do you match your tastes with the price you  pay. You don't want to overpay, but you want to buy the sandwich which you have a taste for. The experimental results show that uncertain prices will influence your purchase decision. This seems logical, but the interesting part of the test is how those choices are made. There is an equal choice of each of the sandwiches being the cheaper one. Consumers learn the price and then have to make a choice. The loss is paying a high price versus expectations for what is considered the inferior sandwich. 

The results show that more loss averse consumers will likely eat the cheaper sandwich no matter what. If the taste is very important, the consumer will never choose the cheap sandwich. Those that place little importance on taste will choose cheap. 

Indifference to taste will always cause a consumer to go cheap given loss aversion. Strong taste preferences may offset the demand to go cheap. This tells us a lot about marketing any product even in money management. Investors will choose a cheaper manager alternative if they do not have strong taste preference. You have to create a taste difference if you want someone to not take the cheap alternative. Define your investment edge if you want to get your 2/20 hedge fund fees otherwise loss aversion will lead to buying cheap without regrets. 

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