Myth: Investors Are Risk-Averse

Alternative investments are still not fully de-stigmatized by many investors, despite the fact that their inclusion in balanced portfolios has proven their merit at least twice during the previous decade. The purpose of this series of reports is to demystify some of the misconceptions still surrounding alternative investments.

Equities were once an alternative asset class too. And then along came Harry Markowitz. The concept Markowitz developed in the 1950s to deal with the investors’ trade-offs transformed the practice of investment management beyond recognition. Markowitz assumed investors were risk-averse. Volatility was used as the metric for risk.

And then along came Daniel Kahneman and Amos Tversky. The two psychologists developed prospect theory and the concept of loss aversion in the 1970s. Prospect theory proposes a descriptive framework for the way people make decisions under conditions of risk and uncertainty and embodies a richer behavioural framework than that of many traditional economic models where it is generally assumed we behave and think like Mr Spock.

Loss aversion is based on the idea that the mental penalty associated with a given loss is greater than the mental reward from a gain of the same size. However, the perception of losses varies over time; it declines in bull markets.

Many investors started to look into hedge funds as a viable investment when markets had peaked in 2000. Falling equity markets put hedge funds and funds of hedge funds on the agenda of many private as well as institutional investors. Why? Because hedge funds have an absolute returns approach while the traditional investment management industry does not.