Interesting interviews with Daniel Kahneman were recently posted, about prospect theory and other key developments in behavioral finance.
According to Thayer Watkins, Daniel Kahneman and Amos Tversky coined the phrase “Prospect Theory” for their studies of how people manage risk and uncertainty, “for no other reason than that it is a catchy, attention-getting name”. Kahneman and Tversky demonstrate that people’s attitudes toward risks concerning gains may be quite different from their attitudes toward risks concerning losses. When choosing between profit opportunities, risk aversion prevails. On the other hand, when confronted with loss making alternatives, people often choose the risky alternative. Although prospect theory is a few decades old, there is still plenty of ground to be covered for pension fund and institutional investors. Just some hypotheses based on prospect theory that need to be explored:
- An active manager with positive alpha will become risk averse, locking in his profits, while the opposite is true with negative alpha. If this this is the case, then prospect theory is a more intuitive explanation of the disappointing results for active managers. In the selection and monitoring of active management this should be a key element.
- Pension fund trustees, when confronted with underfunding, will increase their risk instead of downscaling it. It would therefore make sense to make the risk budget for a pension fund board rules based, with an inverse relationship between cover ratio and risk budget. This is however still the exception, rather than mainstream.
If you have more suggestions on how to fruitful explore prospect theory for pension funds, please let us know!