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Most investors seem less rational than they might admit when it comes to their money. Kahneman and Tversky pointed out 40 years ago in their Nobel-prize winning research: people prefer avoiding losses to acquiring gains. They treat losses and gains differently.

And it may be completely rational. Investors can always achieve better financial outcomes by choosing to moderate large negative returns over seeking positive returns of the same amount. Why? Because after a loss, investors have less capital invested and require a positive return greater than the loss to breakeven – even in target-date strategies. It’s just math.

A Simple Example

We believe a simple example offers insight to the rationality of loss aversion. Our industry inundates your participants with virtually every view of investment performance: daily, monthly, quarterly, calendar year, annualized averages, etc. The numbers are a nice snapshot, but do they represent investors’ experiences?

Their actual experiences often feel different; unfortunately, calculating geometric, or compound, returns is not mental math for most people, yet the result is exactly the outcome your participants experience.

Here’s a quick test: what’s -10% + 10%?

For most of us, the answer is zero unless you’re dealing with compound investment returns. Then the answer is –1%. In investing, the 10% loss causes more damage than a 10% gain, and to work out the combined effect you can’t just add them up, you have to multiply them.

Therefore, loss aversion seems completely rational because investors experience the –1%. Losses don’t compound like gains, which is why investors cringe at volatility.

Here’s the lesson: positive and negative returns of the same magnitude do not have the same impact. This may be the very reason investors treat losses and gains differently.

Winning by Not Losing

Variable beta strategies seek to improve the investor experience by addressing this math. They’re designed to adapt automatically to equity risk regimes in order to protect on the downside yet participate in the upside. A variable beta strategy is a hybrid of active core and low volatility equity strategies.

By reducing the impact of drawdowns, variable beta strategies offer the potential to fuel the “magic” of compounding. This performance contour of upside participation with lower downside capture can affect longer-term outcomes.

 

How Improving Capture Ratios Impacts Long-Term Outcomes

Consequently, variable beta strategies offer the potential to change the value proposition for equities for asset allocators in two ways:

  1. Reduce the total volatility of a portfolio while maintaining the same equity exposure.
  2. Maintain volatility levels while increasing equity exposure to improve return potential.

How to Implement Variable Beta

We’ve illustrated the benefits of adding a variable beta strategy to a target-date strategy in our short case study. Like all asset allocation models, constant risk premia assumptions limit target-date strategies. Such assumptions may subject the portfolios to substantial drawdowns arising from the equity allocation, which reduce compounding benefits and exacerbate poor timing decisions by plan participants. Both have negative long-term return consequences on wealth accumulation.

To see the entire case study, download our latest eBook, “Are Your Asset Allocation Models Exposed Right Now?

Are Your Asset Allocation Models Exposed Right Now?  Learn about an innovative way to address equity risk in your portfolio. Download Now

The information expressed herein is subject to change based on market and other conditions. The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This information should not be used as the sole basis for investment decisions. All content is presented by the date(s) published or indicated only, and may be superseded by subsequent market events or other reasons. Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal and fluctuation of value.

Hypothetical performance results presented (including those in the case studies) are for illustrative purposes only. Hypothetical performance is not real and has many inherent limitations, some of which, but not all, are described herein. It does not reflect the results or risks associated with actual trading or the actual performance of any portfolio and has been prepared with the benefit of hindsight. Therefore, there is no guarantee that an actual portfolio would have achieved the results shown. In fact, there will be differences between hypothetical and actual results. No investor should assume that future performance will be profitable, or equal to the results shown. Hypothetical results do not reflect the deduction of advisory fees and other expenses incurred in the management of a portfolio.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report has not been approved, reviewed, or produced by MSCI.