The systematic inconsistencies that individuals bring to their decision-making processes have led to the development of prospect theory. One key finding from this has been that investors are loss averse, and the average investor theoretically is willing to pay over the odds to protect himself from harm. If the behaviorists are right, it could be possible to extract an excess risk premium over time for a disciplined strategy that underwrites that risk. We believe there are two distinct types of investment themes:
a. Shorting volatility on equity markets
The average investor not only tends to exhibit loss aversion, but also to overestimate the probability of extreme events. This leads to anxiety about a possible loss of capital. As a result, there has been consistently high demand for financial assets that can avoid the discomfort caused by significant capital losses. One example is the equity put option, where the heavy demand for this insurance means investors have a tendency to overpay. Consequently, we believe a strategy that systematically underwrites the insurance they seek should earn a positive premium over the long term.
b. The foreign exchange carry trade
Currency carry is the return an investor can get from borrowing in low-yielding currencies and investing the proceeds in higher yielding ones. On the basis that investors generally dislike inflation, they theoretically would require a lower premium (interest rate) for holding a currency managed by a central bank with a more credible record on containing inflation. The expected currency carry therefore becomes the risk premium offered to the provider of insurance against that systemic risk.