Equities Blog

Pain Reliever: The Behavioral Case for Defensive Equities

23 October 2023

5 min read

Kent Hargis, PhD| Chief Investment Officer—Strategic Core Equities; Portfolio Manager—Global Low Carbon Strategy

David Wong| Senior Investment Strategist and Head—Asia Business Development, Equities

Teresa Keane| Managing Director—Equities

Human behavior can lead to irrational investment decisions, but a well-planned low-volatility strategy may be the antidote.

Human behavior isn’t always rational. Perhaps that’s why so many otherwise thoughtful investors make irrational decisions—locking in losses by selling at the worst possible times or chasing stocks with overextended valuations. Is there an investment strategy that can help offset emotional behaviors that can lead an investor astray?

The Three Layers of the Human Brain

To get to the heart of why investors make irrational decisions, it’s instructive to consider the human brain and its response to pleasure and pain.

Our brains have evolved over millions of years and consist of three layers. At the core is our primitive brain, which provides the fight-or-flight instincts that keep us alive. Overlaying this is a more evolved mammal brain—the source of emotions, memories and habits that aid our decision-making. The highest level of brain function is the neocortex, which helps us process thought, reasoning and self-reflection. This is what essentially makes us human.

Signals from the primitive regions of our brains prompt us to seek pleasure while avoiding pain. But these same signals can overwhelm the neocortex and cause us to behave irrationally. Further knocking our reasoning out of kilter is the human propensity to fear pain much more than we enjoy pleasure.

In the investment world, this can result in some puzzling decisions.

The Loss-Aversion Bias in Action

Here’s an example, based on pioneering research by Israeli behavioral economists Amos Tversky and Daniel Kahneman.

Suppose you have a choice of two doors to enter. You’re told that you have an 80% of winning $4,000 if you open Door A. (Since there’s an 80% likelihood of winning, the expected value is $3,200.) But if you open Door B, you’re guaranteed to win only $3,000. Which would you choose? Tversky and Kahneman found that most participants would choose Door B, which seems an understandable, if not profit-maximizing choice—why gamble if you can get the sure thing? Better to play it safe (Display).

What’s the Rational Choice? Maximizing Gains

Two doors depict a famous experiment by Tversky and Kahneman, who found that subjects tend to choose an option of a certain gain even if it doesn’t maximize their profits.

Source: Amos Tversky and Daniel Kahneman, “Prospect Theory: An Analysis of Decision under Risk,” Econometrica 47, no. 2 (March 1979): 262–291

What happens when the scenario is reversed? Now behind Door A is an 80% chance of losing $4,000—an expected value of $3,200—while behind Door B is a guarantee of losing $3,000. That loss of $3,000 would put a floor to the downside, but it turns out that most participants would rather risk a $4,000 loss for the small chance of losing nothing (Display).

What’s the Rational Choice? Reducing Losses

Two doors depict a famous experiment by Tversky and Kahneman, who found that subjects tend to choose to gamble in an effort to reduce losses.

Source: Amos Tversky and Daniel Kahneman, “Prospect Theory: An Analysis of Decision under Risk,” Econometrica 47, no. 2 (March 1979): 262–291

The takeaway, borne out time and again in research studies, is that loss aversion trumps risk aversion. People will assume more risk to avoid losing money than they will to make money. In fact, Tversky and Kahneman concluded that humans feel the pain of loss two to three times more acutely than they feel pleasure of gain (Display).

Humans Experience Pain More Intensely Than Pleasure

Schematic graphic based on Tversky and Kahneman’s research depicts how people feel pain much more intensely than pleasure.

Source: Amos Tversky and Daniel Kahneman, “Advances in Prospect Theory: Cumulative Representation of Uncertainty,” Journal of Risk and Uncertainty 5, no. 4 (1992): 297–323

This ratio can clearly have implications on investment decisions. Defensive equity strategies offering a pattern of performance that gives up a little bit of upside in rising markets in return for downside risk reduction that’s two to three times as much may be aligned with human nature. More on that idea shortly.

Investors Can Overestimate Their Stock-Picking Prowess

Another human bias is overconfidence. A 1999 study of nearly 80,000 US households found that households that traded the least frequently—as measured by portfolio turnover—enjoyed annualized returns 7 percentage points higher than households that traded the most. Researchers attributed this difference to investors’ overconfidence in their own stock-picking ability—overconfidence that resulted in lower returns (Display).

Overconfidence: More Trading Doesn’t Lead to Greater Returns

Chart shows the results of a 1999 academic study that found investors who traded less frequently enjoyed much higher annualized returns than those who traded frequently.

Historical analysis does not guarantee future results.
Monthly trading results for 78,000 US households
Source: Brad Barber and Terrance Odean, “The Courage of Misguided Convictions,” Financial Analysts Journal 55, no. 6 (Nov.-Dec. 1999): 41–55

All too often, investors let behavioral biases like loss aversion and overconfidence affect their investment decisions. Fortunately, there’s an investment philosophy that can help overcome both overconfidence and risk-aversion biases.

The Case for Low-Vol Equity Investing

Consider an equity investment strategy that aims to limit downside capture—that is to say, exposure to falling markets—while participating in market gains, but not fully. This theoretical portfolio could be designed to capture 90% of the market’s gains in rallies, while falling only 70% as much as the market during downturns.

How does this 90%/70% defensive strategy help mitigate behavioral biases?

By targeting stocks that strike a balance between offense and defense, low-volatility investing reduces exposure to overvalued stocks that investors might chase due to overconfidence.

But this strategy really shows its mettle during falling markets. If successful, the portfolio would fall, on average, only 70% as much as the broader market. This helps takes the sting out of losses—counteracting the loss-aversion bias that might prompt investors to pull out of the market prematurely. It can also help counteract investors’ overconfidence in their ability to time turning points in the market, which is almost impossible to do consistently. Research shows that missing the five best days of a market rebound can have a profound impact on long-term returns (Display).

Trying to Time the Market Can Be Risky

Bar chart shows that investors who missed the five best days of the S&P 500 between 1988 and 2022 suffered much lower returns than investors who stayed in the market.

Past performance is no guarantee of future results.
As of December 31, 2022
Source: Bloomberg, Lipper, S&P and AllianceBernstein (AB)

That’s because stocks that lose less in market downturns have less ground to regain when the market recovers. As a result, they can compound from a higher base during subsequent rallies.

While you might expect a low-volatility strategy to underperform over time, historically just the opposite has occurred.

Active Management Can Help Balance Risk and Return

Using data from March 1986 through June 2023, we found that a hypothetical 90%/70% portfolio would generate annual returns 3.1 percentage points higher than the MSCI World Index over this period—with less volatility in the process. We believe that the key to building such a portfolio is to focus on high-quality stocks with stable trading patterns at attractive prices (QSP stocks). Active management that utilizes thoughtful, fundamental research to find QSP stocks provides investors with more levers to manage volatility—critical in today’s environment of higher rates, macroeconomic uncertainty and geopolitical instability.

Humans are going to be human. But by understanding how inborn emotional responses can be an investor’s worst enemy, we believe that a low-volatility strategy can be constructed that counteracts behavioral biases and helps deliver better investment outcomes over time.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.

About the Authors

Kent Hargis, PhD

Kent Hargis is the Chief Investment Officer of Strategic Core Equities. He created the Strategic Core platform and has been managing the Global, International and US Strategic Core portfolios since their inception in 2011. Hargis has also been Portfolio Manager for the Global Low Carbon Strategy Portfolio since 2022. Previously, he managed the Emerging Portfolio from 2015 through 2023. Hargis was global head of quantitative research for Equities from 2009 through 2014, with responsibility for directing research and the application of risk and return models across the firm’s equity portfolios. He joined AB in 2003 as a senior quantitative strategist. Prior to that, Hargis was chief portfolio strategist for global emerging markets at Goldman Sachs. From 1995 through 1998, he was assistant professor of international finance in the graduate program at the University of South Carolina, where he published extensively on various international investment topics. Hargis holds a PhD in economics from the University of Illinois, where his research focused on international finance, econometrics and emerging financial markets. Location: New York

David Wong

David Wong is a Senior Investment Strategist and Head of Asia Business Development for Equities. He joined AB in March 2015, bringing two decades of experience in global equity markets to the firm. Prior to joining AB, Wong was a partner at Janchor Partners, a Hong Kong-based long/short equity hedge fund with US$2 billion in assets under management (AUM). Before that, he had set up the Hong Kong office for GMT Capital, an Atlanta-based long/short equity hedge fund with $5 billion in AUM, where he served as portfolio manager and head of Asian investments. Over Wong's eight years at the two hedge funds, he was responsible for global investments in technology stocks, and also served as a generalist portfolio manager for the Asia-Pacific region, including Japan. He was also the founder and managing director of Mobile Adventures, a pan-Asian wireless content company. Wong started his career as an equity research analyst at Bankers Trust and Deutsche Bank; at Deutsche, he managed a team of five associates as the firm's regional semiconductor analyst. He holds a BA in political science from Yale University. Location: Singapore

Teresa Keane

Teresa Keane is a Managing Director of AB's Equities business. She has worked with the Strategic Core/Low Volatility Equity platform since inception in 2011 and with AB's Concentrated platform since 2018. In this role, Keane works extensively with the firm's research and portfolio-management teams, as well as with clients around the world. She joined the firm in 2000 when Bernstein was setting up its London office. Before joining the firm, Keane worked at Lazard Asset Management and Moody's Investors Service. She holds a BA from Dublin City University and is Investment Management Certificate qualified. Location: London

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