The effects of psychology on expected return

In previous article we talked about using expected return formula to make investment decision (Read more here).  This simple yet robust approach can easily distinguish the risk adjusted return of an investment vehicle over the long run.  However, there are cases where the investors prefer lower expected return due to psychological influence.

Example,

Jack came across a promotional material about a fast-growing fund named SCK Fund.  When comparing with conventional utilities sector focused ENW fund, SCK fund could generate 30% annual return while ENW fund could generate 6% annual return.  After talking to several investors on these funds, Jack found that the return on SCK fund was relatively volatile with 50% chances that it could generate either 30% or -25% returns.  Meanwhile, ENW fund performance was fairly stable, the ratio of generating 6% and -1% returns were 80:20.  Many SCK fund investors told Jack to pick SCK fund even though it had higher risk, because they believed that higher return always come with higher risk.  If you were Jack, which fund would you prefer?

Let’s do the math.

ENW fund

E(R)        = (p)(R_W) + (1-p)(R_L)

                = (0.8)(6%) + (0.2)(-1%)

                = 4.6%

SCK fund

E(R)        = (p)(R_W) + (1-p)(R_L)

                = (0.5)(30%) + (0.5)(-25%)

                = 2.5%

Based on the expected return calculation, ENW fund was a better choice but many investors might opt for SCK fund due to the attractive higher return and also, sometimes, the marketing influence.