Be aware of absolute returns, because it’s a relative world

Is it possible for a human being to manage an absolute-returns fund? If you believe the latest behavioural finance research, it must be very difficult.

Money has an absolute value, or so we think. $10 is $10 is $10. But the prices for goods vary and it seems that the utility we get from the same $10 varies between different types of goods. And how we view the value of the alternatives is affected by what those alternatives are.

Professor Dan Ariely, in a study reported in a new book, Predictably Irrational, showed 100 MBA students three different options for subscribing to The Economist newspaper – options that actually appeared in a real advertisement – like this:

Website-only subscription: $59.00 per year

Print-only subscription: $125.00 per year

Print & web: $125.00 per year

There’s something strange going on here – why include two options, one for print-only and one for print and web at the same price? First let’s look at how many chose each of these options:

Website-only subscription: 16

Print-only subscription: 0

Print and web: 84

Unsurprisingly, the students preferred the print and web over the print-only. Most also went for the higher-priced option over the cheaper website-only option. But look what happened when Professor Ariely took out the middle print-only subscription option. So now they are choosing between website-only and print and web:

Website-only subscription: 68

Print and web: 32

What a difference that option makes to The Economist’s subscriptions.  Suddenly, most people are plumping for the cheap option rather than shelling out for the pricey print and web option. What’s going on?

Ariely explains that this shift is down to our preference for avoiding comparing things that are too dissimilar. In this experiment the easy option is comparing print with print-and-web. It’s obvious how much better print-and-web is than just print. Who would choose print-only for the same price? The website-only option gets ignored because it’s difficult to compare it with the other two options.

But, once the print-only option is removed, we’re stuck comparing dissimilar items, so then students go for the cheap option as suddenly this seems a safer choice.

All this is reported in a psychology newsletter called PsyBlog, which collates recent research on all aspects of human behaviour, including the link between investment or “money behaviour” and common practices.

The point of this, getting back to the original question, is that human beings make financial decisions in a relative framework, rather than an absolute one.

To manage money in a “benchmark-unaware” fashion, as pension funds look to do with at least parts of their portfolios, the managers have to get themselves into a completely unnatural frame of mind.

If everything is relative, as the saying goes, then one’s natural instinct has to be overridden in an absolute-return environment. The evidence is that absolutes are not easily come by.

*Greg Bright is the Beijing-based publisher of www. top1000funds.com