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Behavioural finance and rational thinking

Over the past week, we witnessed a rise in cognitive dissonance. Cognitive dissonance appears when two or more discernible elements – this can be an opinion or piece of new information – conflict with each other. Inflation readings, inflation expectations versus terminal rate estimates or wage inflation versus unemployment are typical examples where dissonance might occur in the eyes of the beholder. We all want to reduce cognitive dissonance as we want to avoid the impact, and pain of a poor self-image. People tend to minimise or reject information that exposes their wrongly-held beliefs or investment stance. We have reached a point in the investment cycle where conflicting messages might start to outnumber consensus calls that support conservatism. Conservatism, defined as the phenomenon that investors only gradually adjust their views –be it asset allocation or portfolio construction – to new information, might or should be waning.

The release of the US CPI inflation numbers has been a case in point and requires some reflection. However, surprisingly, we will not discuss whether the latest batch of inflation numbers represents an inflection point. Whether, by November 2023, US inflation will settle at 2.9% priced through zero coupon 1-year inflation swap or at 2.48% priced through the 1-year inflation break-even rate or 5.1% as released through the University of Michigan 1-year inflation forecast, is open for debate. I want to address cognitive dissonance at the macro-level: I describe this as the choice between a rational investment stance versus outcomes that prospect theory might deliver or not.

Under a rational approach, an investor wants to maximise their expected utility by taking the weighted sum of possible outcomes, whereby each weight represents the probability that the corresponding outcome will be reached. What few realise is that such a rational investment approach is only interested in the utility of the final outcome or final state. One should not worry on how that final stage is reached. Applying such an investment stance has certain benefits at this juncture, after a 2022 valuation reset with a historically high amplitude. Indeed, across bond sectors, expected returns over respective investment horizons have settled between 3.25% (for EU government bonds) and 7.25% (for EUR HY including default probabilities). In between, one can find expected returns in USD Treasuries at around 4%, EUR IG credit at around 4.75%, USD IG credit at 6.5% or emerging market government bonds in local currency ranging between 7.5% and 8% depending on risk profile. The equity asset class rerated as a result of an aggressive spike in discount rates next to retracements in future earnings estimates. A rational investor weighs probabilities, for instance of the level and by when policy terminal rates will be reached, as priced by markets. In addition, probabilities of future inflation paths based on various market estimates & surveys (see above) provide a clear signal that points to a neutral stance across rates. Current default probabilities and forward earnings estimates point to relatively fair pricing across credit and equity. Naturally, we have to account for a different definition of neutral across investor types.

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Finance in 2040 by our experts : Cara Williams