A series in Institutional Investor examines eight common traps money managers fall into. This article focuses on “value traps” – seemingly stable value investments that aren’t a good use of capital:
Investments with little downside, but also limited upside (Value Traps) can gain prominent position sizes because of their limited risk, but end up being poor use of capital. This inefficiency is caused by the basic human instinct of loss aversion. Tversky and Kahneman, pioneers in cognitive psychology, found that the disutility of a loss is about 2x greater than the utility of an equal gain. What this means is that the pain of a loss of $100 is about the same as the pleasure of winning $200. This effect explains how emotion takes over when losses occur. Compounding may explain this emotional response because the impact of a portfolio loss is more detrimental than a commensurate gain is beneficial. So, our instinct is partially right to love an asset with downside protection, but the cost of downside protection must be measured. Read the full article.