Put-call ratio signalling red for contrarians

Options markets are exhibiting two unusual dynamics at the moment that can provide some insight on investor positioning and sentiment. For contrarians, the signals suggest the market is underprepared for disappointment on politics, virus, unemployment or anything else for that matter.

Firstly the Put-Call ratio is tracking at close to 20-year lows. This ratio references the number of put options held by investors versus call options. Investors will typically buy put options for protection and call options to express a bullish view, so when the balance changes it can reflect a change in investor sentiment and positioning.

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A miserly outlook for franking credits

As published on Livewire Markets, 14 July 2020

While all eyes have been focussed on falling dividends this year, there has been little discussion around the negative impact this will have on the franking credit benefits that are attached to these Australian yields.

Franking credits provide an important source of cash return to many eligible investors, on average accounting for around 1.65% of total return over the past 5 years.

Investors would have been particularly pleased with calendar 2019, a bumper year for franking credits with nearly 2% returned as companies boosted dividend payments ahead of the Federal election. Franking credits are calculated and paid on a fiscal year basis, however analysis of the calendar year is useful to provide some guidance on where franking credit returns are likely to head in the future.

A more miserly 2020 for franking credits

On this basis, returns from franking credits this year are likely to be far more miserly than 2019. We estimate that the calendar year to date contribution from cash dividends to shareholder return has fallen by over 40% for the 8 months to 31 August 2020, from the prior equivalent period.

Given the magnitude of the fall, a decline in franking credits is no doubt also expected. On our estimates, returns from franking credits this calendar year have only totalled 0.67% versus the 1.45% generated at the same point last year, with the percentage decline more than matching the decline in cash dividends.

The marked decline in franking benefits corresponds with the fact that the largest cuts to dollar dividends have been made to previously fully franked dividends, for the most part. The major cuts to bank dividends, which are all fully franked (except ANZ), in addition to the withdrawal of special dividends from BHP and RIO have all contributed to the material ‘shrinkage’ of the franking credit pool in 2020.

As these 6 stocks accounted for over 43% of the total cash dividend on the ASX200 in the past 12 months, and they were mostly all fully franked, the pool of fully franked dividends has declined more than the broader cash dividend generated by the ASX200 in percentage terms (as the broader index includes many stocks with partial or no franking credits attached, that did not see the same quantum of declines).

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Using global shares to break your dividend dependency

As published on Livewire Markets, 14 July 2020

Global equities are usually added to a portfolio for one reason – to increase diversification. With the Australian equity market representing only 2-3% of global equity exposure, plus very high sector concentrations in the local market, the benefits of global diversification are particularly meaningful for Australian investors.

However, leaving geographical considerations aside, how much diversification is actually being delivered at a sector and factor level? When income is the main consideration, the global equity sectors that generate the highest dividend yields are typically concentrated in the same sectors that dominate the Australian market. As a direct result, ‘going global’ may unwittingly ‘double down’ on these identical high yield sector exposures, albeit in a different geography, and thus fail to maximise the diversification benefit.

One solution to this problem is to introduce an alternate source of income that does not rely upon dividend yields. Buy-Write strategies are an established and well-proven solution to yield generation that breaks the connection with dividend dependency. Global Buy-Write strategies can offer genuine diversification at both the sector and country level as well as providing a regular income stream and an element of capital stability.

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How much risk is embedded in your income?

With interest rates at record lows, many investors are being forced into assuming greater risk in their portfolios to generate acceptable levels of income. As an example, bank term deposits are currently yielding a meagre 1.7% pa compared to the 40 year average of over 6% pa. As a consequence, investors who rely on income as a primary source of return are being forced into making more risky investment decisions to sustain their lifestyles.

Typically, retirees comprise a large portion of this ‘yield dependent’ investor class which is a cause for concern because they are often at a stage where they should be decreasing the risk in their portfolios.  There are well-documented reasons to support this such as sequencing risk, shorter investment horizons and liquidity risk to name a few. Hence, achieving the optimal mix between yield and risk in a balanced retirement portfolio has possibly never been more important.

The relationship that exists between yield and risk has been applied across a selection of major asset classes in the chart below. In the first instance, we define risk as price volatility, and secondly as the drawdown experienced during the recent market rout (ie 20 February to 23 March 2020). The relationship is consistent across both metrics.

Figure 1: How much capital volatility is embedded in your income?


Figure 2: How much capital drawdown risk is embedded in your income?

In the analysis above, the blue trendline plots the relationship between increased yield, and increased risk. Investments above the line represent more efficient income portfolios for the risk assumed and conversely those below the line less efficient. The returns on cash were used as an anchor point for both risk assumptions, so to make valid comparisons with a mostly ‘risk-free’ 1.7% income return on cash.

The conclusions are readily apparent, but it is worth elaborating on the details.

  • Australian Equities – In order to achieve an equivalent 6% income yield in the current environment, Australian equities (and importantly, their attached franking credit benefit), are one of the few asset classes that come close. The 5.9% gross yield assumes some level of dividend cuts during 2020, with a rebound in yields (at least from the banks) unlikely in the foreseeable future. Despite this, as their position above the blue trend line indicates, Australian equities appear to provide not only one of the highest yields, but also one of the most efficient yields when risk is considered.
  • Hybrids – Given the underlying sector exposure of many convertible issues is banking, capital values held up very well relative to the 40-50% falls seen in bank share prices during the recent drawdown. Hybrids present different risks compared to other asset classes, as in certain circumstances the issuer can decide to ‘convert’ the security to more risky equity (potentially at the worst time for the holder), plus withhold coupon payments. Both of these characteristics create additional risks relative to standard fixed income securities, and are intentionally designed to add value to the issuer during times of extreme credit stress. We believe the numbers in the above analysis understate these risks and if fully considered would move the yields below the efficiency line.
  • Australian Investment Grade Corporate Bonds – Average yield to maturity for Australian IG corporate bonds is currently returning 3.0%, significantly lower than average coupon rates of around 6%. The difference is explained by the decline in Australian interest rates which has pushed most bond prices well above par. Liquidity and breadth of market exposure are more difficult to achieve within the Australian corporate bond market, which in our view is a significant compromise for the slightly better than average yield versus risk relationship.
  • AREITs – Subsequent to the near 50% fall during the Coronavirus rout of Feb 20 – Mar 23rd, the ASX 300 AREIT Index has only partially recovered and remains down 25% year to date. The asset class was acutely exposed to the pandemic due to its high retail sector exposure and the evaporation of foot traffic. Assisted by the capital decline, the Index is currently indicating a 6% yield although we question the delivery of this yield in the 12 months ahead. The drawdown highlights the lack of diversification within the AREIT index, with the 6% yield, even if achievable, screening unfavourably relative to the risk.
  • Global Infrastructure – Along with AREITs, this sector was heavily exposed to the Coronavirus pandemic due to sudden demand destruction in global transport and electricity generation.  While low interest rates globally have typically been supportive for capital values (resulting in improved drawdown characteristics versus other equity-based asset classes), current yields of 3.5% fall well below the trendline for ‘equivalent risk’ versus other asset classes.


Dollar for dollar, within conventional asset classes it remains difficult to go past Australian equities in terms of yield generation for the risk assumed. Even with the high exposure to financials the yield is relatively more diversified than many other typical income sources that have a high factor concentration, plus it offers ample liquidity and includes the possibility of capital growth that is not included in the above analysis. IG Bonds and Hybrids may also play a role in terms of delivering diversified sources of ‘risk efficient’ income, however breadth, liquidity, and credit deterioration (especially for hybrids) could prevent inclusion in some portfolios.

For investors willing to venture past the more ‘conventional’ asset classes there is the Wheelhouse Global Equity Income Fund.  In this case ‘less conventional’ does not mean ‘more risk’ but rather the exact opposite.  The Wheelhouse approach delivers a materially beneficial yield for less risk when compared to conventional alternatives, with none of the liquidity, diversification, or factor dependent risks.

Wheelhouse Global Equity Income Fund

At Wheelhouse, we recognise that income is only as good as the security of the capital that is generating it. Our unique process is outcomes-focused, and seeks to deliver a real 7-8% income stream while assuming the lowest risk possible – typically around half the equity market’s risk.

Where are we different? The funds approach to income generation and capital protection is unique, and different to all conventional strategies.

  • Income – The fund is based on a diversified global portfolio of shares. Global shares are typically known for growth, but not yield. The ‘unconventional’ difference is the use of a systematic derivative overlay that coverts capital growth into a reliable 7-8% income stream.
  • Protection – The second ‘unconventional’ difference is the use of an ‘always-on’ protective hedge, that preserves capital in market drawdowns. This insurance mindset will usually cost a little income during normal times, but then deliver in spades when it is most required.

With the Fund passing its three-year milestone this month, both the yield and the risk have proven consistent across a variety of market scenarios, as evidenced in the analysis above.

Yield vs risk – or as we call it, income and protection – that’s all we do.

Source: Wheelhouse

Asset class proxies

Aust IG Bonds                           Solactive Australian Investment Grade Corporate Bond Select Index (SOLAUSIG).

Hybrids                                    Solactive Australian Hybrid Securities Index (SOLAUDHG). .

Global Infrastructure                 FTSE Global Core Infrastructure 50/50 Net Total Return Index in AUD

AREITS                                    ASX-300 AREIT Index


Download a copy of the article here.

Market crash highlights the value of tail-protection

What are tail risks?

Within financial markets, ‘tail risk’ events refer to rare and unpredictable events that can cause sudden sharemarket crashes. While there is a statistical definition (a greater than three standard deviation movement from the mean), in layman’s terms the price movements of the past month are a very good example of a tail risk event.

Tail risks are notoriously difficult to predict, and often fall outside of the ‘expected’ market return profile of a normal distribution. This creates a problem for many asset allocation and risk management models, which rely upon ‘normally distributed’ returns to assess and analyse expected returns. In reality – and particularly in times of crisis – these models systematically under-estimate the risk of loss, in large part to the nature of crashes which can be extremely vicious on the way down.

For example, our analysis of the MSCI World Index for the period 1970-2017 shows that observed tail risk events occurred 6-8 times more frequently than these models suggested, when based on a normal distribution.

Frequency of tail risk events for MSCI World, 1970 – 2017

Source: Wheelhouse

Furthermore, during periods of higher than average market volatility, research by Peters (2009 & 2014) suggests the risk is not 6-8 times more likely, but more than 20 times more likely!

After a 12-year period of relatively muted volatility and strong equity price gains, it does appear we are on the cusp of a period, potentially extended, of high market volatility and uncertainty.

Impact of tail risk events

There are two major impacts of tail risk events on investor outcomes.

1. Sequencing risk

Large losses, particularly in the 5-10 years immediately preceding and after retirement, can be devastating in terms of outcomes. This well-documented issue is known as sequencing risk, and is particularly relevant for retirees and pre-retirees due to the large sums of money involved; the relative lack of time that retirees have to recover from these losses; and the necessity for retirees to draw down income during these periods.

In our report The retiree and the 100-year storm we provide an example of sequencing risk in some detail.

2. Behavioural loss aversion

Compounding the sequencing risk dilemma is the behavioural finance theory of loss aversion, referring to the human preference of avoiding losses more than acquiring equivalent gains. Put simply, the pain of losing $100 is more pronounced than the joy of making $100.

Studies have shown that retirees are far more sensitive to this ‘emotional magnet’ than any other age cohort.

Well-crafted long-term investment plans can be disregarded overnight, as investors that are weighing the emotional response of a sharp loss look to move to the relative safety of cash at precisely the wrong time. However, by selling at the bottom when much of the damage has already been wrought, losses can be effectively locked in and longer-term investment outcomes more difficult to achieve.

What type of tail risk protection strategies are there?

For most people, the move to retirement should also include an increased allocation to more defensive asset classes, such as cash or fixed income. While these more defensive allocations will usually help defend capital during a tail event, in the more recent low-interest rate environment these allocations have also come with significantly diminished returns. Low interest rates, combined with increasing investor life expectancies, may actually serve to increase the likelihood of a critical failure such as a retiree outliving their savings.

Within equities, increased allocations to more defensive sectors such as utilities and consumer staples can also assist. However, there comes a point where correlations for all stocks and sectors increase, something we have witnessed in the past week or so.

An alternate solution, and one we employ systematically at Wheelhouse, is actively managed tail protection that relies on derivative overlays, and the principles of insurance. Our tail protection strategy, once engaged, physically increases in value for every move down in the market. In fact, the way our strategy is designed is that the hedge increases in value at a faster rate than the market is falling. This means that the worse the market falls, the more our hedge goes up.

As an example, one protective trade we entered in mid-February 2020 (when market conditions were benign) for $4.62 had increased in value by over 50x and was monetised for an average $248.32 in mid-March. In the current environment, hedging a portfolio is as expensive as it was at the peak of the GFC and really validates the Wheelhouse approach of having protection ‘always on’. These little ‘sleeping securities’ are expected to cost performance around 1.0-1.5% over the year, but during market stresses they increase in value exponentially. The chart below illustrates the performance of the tail hedge in the Wheelhouse Global Equity Income Fund year to date, where it has added 700 basis points year to date, and nearer 720 basis points since the market commenced its decline.

Source: Wheelhouse

Similar to insurance, tail protection needs to be managed. Trying to buy flood protection after the rain has started, or hurricane protection after the storm, is typically an expensive exercise. However, when ‘always on’ and actively managed, insurance policies put in place before the market turmoil can increase significantly in value.

In retirement, we believe many portfolios would benefit from an insurance mindset. For example, when we are young and working our primary asset is our salary, or our human capital, that we rely upon to provide for ourselves and our families. Thus it comes as no surprise that we often take out ‘income protection’ type policies to protect that human capital.

As we move into retirement, that human capital becomes financial capital, or our investments and savings. With decreased opportunity to return to work as we age, we believe our financial capital should be protected in a similar fashion – namely with tail risk protection strategies. By protecting capital, this allows income to be generated on a more stable financial base. For retirees, we believe this combination of income and protection is key.


This information is issued by Bennelong Funds Management Ltd (ABN 39 111 214 085, AFSL 296806) (BFML) in relation to the Wheelhouse Global Equity Income Fund. The Fund is managed by Wheelhouse Partners, a Bennelong boutique. This is general information only, and does not constitute financial, tax or legal advice or an offer or solicitation to subscribe for units in any fund of which BFML is the Trustee or Responsible Entity (Bennelong Fund). This information has been prepared without taking account of your objectives, financial situation or needs. Before acting on the information or deciding whether to acquire or hold a product, you should consider the appropriateness of the information based on your own objectives, financial situation or needs or consult a professional adviser. You should also consider the relevant Information Memorandum (IM) and or Product Disclosure Statement (PDS) which is available on the BFML website, bennelongfunds.com, or by phoning 1800 895 388 (AU) or 0800 442 304 (NZ). BFML may receive management and or performance fees from the Bennelong Funds, details of which are also set out in the current IM and or PDS. BFML and the Bennelong Funds, their affiliates and associates accept no liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information. All investments carry risks. There can be no assurance that any Bennelong Fund will achieve its targeted rate of return and no guarantee against loss resulting from an investment in any Bennelong Fund. Past fund performance is not indicative of future performance. Information is current as at 16 March 2020. Wheelhouse Investment Partners Pty Ltd (ABN 26 618 156 200) is a Corporate Authorised Representative of BFML.

COVID-19 crisis – the value of income and protection

The evolving COVID-19 crisis remains fluid, and all measures of risk have increased alongside the market’s fall.

At Wheelhouse, we never attempt to predict the direction of market movements. Rather, we eye the world through a consistent defensive lens that is always more concerned with downside risk, versus how much we stand to make should markets recover.

Our key objectives are to deliver a consistent 7-8% real yield, while assuming only around half the market’s risk. Our defensive approach is based on the following two investment processes that integrate to deliver a highly predictable return profile, even during market crises.

1) Income generation

Income generation has increased materially since the market drawdown commenced. In mid March, gross income generation is already over two times the usual average. This income stands between us and a loss, and forms part of our real return generation.

It’s worth highlighting that the heightened volatility in the market provides an opportunity for our systematic overlay to harvest outsized income returns. For example, one-month index options on the S&P 500 are currently generating nearly 5% in income for the month, or nearly 60% annualised return.

The Wheelhouse Global Equity Income Fund is well positioned to exploit this differentiated source of return and is systematically monetising this opportunity.

Source: Wheelhouse. Figures correct at 16 March 2020.

2) Capital protection

A unique aspect of our downside protection is our ‘always-on’ tail risk protection strategy, which is designed to engage in more acute or sudden drawdowns of typically greater than 10% in magnitude. The tail hedge is designed to reduce risk aggressively in market corrections, without the need to sell a single share. During these periods we actively manage the protection, extracting value wherever we can yet maintaining similar protective coverage of around 50-60% of the market risk.

Year to date the protective tail hedge has added 700 basis points in value, during which time we extracted over 300 basis points in cash which is added to our investors’ returns – no matter what happens next in the market.

Source: Wheelhouse. Figures correct at 16 March 2020.


For performance information, see our latest monthly report.



This information is issued by Bennelong Funds Management Ltd (ABN 39 111 214 085, AFSL 296806) (BFML) in relation to the Wheelhouse Global Equity Income Fund. The Fund is managed by Wheelhouse Partners, a Bennelong boutique. This is general information only, and does not constitute financial, tax or legal advice or an offer or solicitation to subscribe for units in any fund of which BFML is the Trustee or Responsible Entity (Bennelong Fund). This information has been prepared without taking account of your objectives, financial situation or needs. Before acting on the information or deciding whether to acquire or hold a product, you should consider the appropriateness of the information based on your own objectives, financial situation or needs or consult a professional adviser. You should also consider the relevant Information Memorandum (IM) and or Product Disclosure Statement (PDS) which is available on the BFML website, bennelongfunds.com, or by phoning 1800 895 388 (AU) or 0800 442 304 (NZ). BFML may receive management and or performance fees from the Bennelong Funds, details of which are also set out in the current IM and or PDS. BFML and the Bennelong Funds, their affiliates and associates accept no liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information. All investments carry risks. There can be no assurance that any Bennelong Fund will achieve its targeted rate of return and no guarantee against loss resulting from an investment in any Bennelong Fund. Past fund performance is not indicative of future performance. Information is current as at 16 March 2020. Wheelhouse Investment Partners Pty Ltd (ABN 26 618 156 200) is a Corporate Authorised Representative of BFML.

Volatility – precursor to bear market, or correction?

Watch this interview with Alastair MacLeod of Wheelhouse Partners, appearing on YourMoney, to hear his views on:

  • Whether current volatility is a portent to a bear market, or the correction we’ve been wanting;
  • The effect of a protracted period of low interest rates;
  • Performance of growth versus value stocks; and
  • Why we feel short-term losses so acutely – even though we logically know investing is most effective over the long term.

Changing the shape of retirement

Most people are aware that buying lottery tickets makes no sense. From a rational assessment of risk and return, the value of the ticket is probably less than the paper it’s printed on. And yet despite this, the lottery ticket industry continues to harvest its outsized return – in part because of our humanistic tendency to overweight low probability events and make decisions on this basis.

The same behavioural forces are at work during times of market volatility or crisis. Retirees in particular are evidenced to be most vulnerable to making decisions against their best financial interests, at the worst possible times. Despite many retirees having long-term, well-crafted investment plans in place, market volatility can turn these plans into ‘impatient capital’ overnight, with extremely damaging consequences. Unfortunately it’s common to hear the story of a friend or relative who, driven by fear, moved to cash at the bottom of a market cycle.

The primary reason for this seemingly irrational behaviour is our cognitive bias – instinctive decision-making that is hard-wired into us at birth. This was the focus of Daniel Kahneman and Amos Tversky’s pioneering work on prospect theory, which has formed the bedrock of modern behavioural finance theory. Prospect theory holds many of the answers as to why humans tend to lack reason when it comes to financial decision-making.

We believe a thorough understanding of the ‘emotional magnets’ that pull us away from rational decision-making can assist in retirement strategy design. By recognising these cognitive biases – and importantly, by building retirement portfolios that take these biases into account – we believe retirees are better placed to adhere to their long-term plans and thus realise their targeted outcomes. Advisers, too, know that a less stressful financial journey makes for a happier client/adviser relationship, where both parties benefit.

At Wheelhouse, our mission is to improve investment outcomes for retirees. Delivering equity growth in an income-driven and retiree-friendly shape is integral to our philosophy.

What is prospect theory?

The term ‘prospect theory’ describes how people choose between different options (or prospects) and how they estimate (many times in a biased or incorrect way) the perceived likelihood of each of these options. It was pioneered by Daniel Kahneman and Amos Tversky in 1979 as a pragmatic model for explaining real-world choices and how these can systematically override optimal decision-making in many situations, especially financial. The theory has been lauded as a milestone in economics, and based on citations is regarded as one of the most influential studies in explaining how human cognitive biases can often impair rational decision-making processes.

The theory was a dramatic departure from previous utility-based models, whereby academics portrayed human decision-making as perfectly rational and argued that probability-weighted outcomes would serve as the basis for determining risk and return. Utility theory was based in part on the view that investors would focus on the final wealth outcome, or the probability-weighted return, and rely on this as a key consideration in decision-making.

Kahneman’s key departure from this view was that in the real world, investors are more likely to prioritise gains or losses from a current reference point and treat these gains or losses differently from a value perspective. In other words, the path of investment returns is more important than the final wealth destination.

A critical consideration in assessing this path is the concept of loss aversion. This is illustrated in the following chart, where for a given gain or loss, the perceived value is treated very differently. At the breakeven reference point (0), the value function is kinked and losses deliver significantly greater negative utility than equivalent gains.

Put simply, the pain felt from losing $100 is sharper than the joy of making $100.

  • Gains/ losses relative to a reference point are more important than overall wealth at the destination (the path of returns matters).
  • Value function is kinked at the reference point (0). The fear of losses loom larger than the prospect of equivalent gains (Kahneman estimates 2:1 for losses and 1:1 for gains close to the reference point).
  • The function is concave for gains and convex for losses.

There are a number of other ground-breaking conclusions to come out of prospect theory (explaining why Kahneman was awarded a Nobel Prize in 2012), some of which are outlined below.

Overweighting small probabilities

This is the main feature of the probability weighting function (refer to the following chart), and explains the simultaneous demand for both lotteries and insurance.

Insurance is the mirror image of the aforementioned lottery tickets – whereby even though the likelihood of a costly event may be miniscule, most of us would rather agree to a smaller, certain loss (the premium paid) than risking a large expense. The perceived likelihood of a major health problem is greater than the actual probability of that event occurring. There’s a reason insurance companies are some of the oldest on the planet.

There are numerous examples of people under-estimating more frequently occurring or common risks. For example, a recent study of Australian hospital data[1] reports that that nearly 40% of all injury-related hospital admissions in Australia were due to falls, versus 13% for transport accidents. For Australians aged over 65, the rate for falls increases to more than three quarters of all hospital admissions. And yet most of us perceive driving to be a riskier activity than the daily event of taking a shower.

There is an extension to this bias, where it is observed that people will ascribe more weight or value to the complete elimination of a given risk, as opposed to an equivalent reduction in risk. This principle is often evident in the pricing of insurance, where risk removal is priced differently to risk reduction (witness a high excess versus no excess and the subsequent effect on an annual premium). It is also often reflected in the pricing of many capital protected type instruments.

The following diagrams highlight the concepts of loss aversion, overweighting small probabilities, and an investor’s focus on relative gains or losses (the path of returns) as opposed to the final wealth outcome.

The first example shows that investors are far more likely to accept potential underperformance in exchange for increased certainty of a gain. When gains are being considered, ambiguity is penalised and investors opt for the certainty of $900.

Conversely, when losses are under consideration, the sting of loss looms large and investors take more risks to avoid it. By overweighting the low probability of a $0 loss, investors gravitate to the riskier option even though they should be completely indifferent as to the probability weighted final wealth outcome.

Framing and mental accounting

Framing describes the tendency for people to use a reference point as the benchmark for comparisons. As mentioned, this is a key difference to utility-based models which focused on final wealth outcomes.

In the example below, investors are given an initial sum of money and asked to choose between alternate scenarios. In either case the final wealth positions (total gains) are exactly the same across both scenarios. Under utility theory, an investor should choose the same option in either scenario – but in reality this rarely happens. The starting point matters, as it determines the path to the final wealth destination.

In Scenario 1, investors are overwhelmingly more likely to accept a certain gain of $500 (risk-averse behaviour). However, when faced with relative losses, investors focus on minimising the sting of loss – even if this means the possibility of losing $1000 in order to deliver zero loss (risk-seeking behaviour).

When gains are being evaluated, ambiguity is penalised – but the preference for avoiding ambiguity is less established when facing the prospect of losses. In other words, investors are assessing their path and altering the perceived risks according to their biases, as opposed to focusing on the final wealth attained (which is equivalent).

Mental accounting is a similar concept to framing and, while part of prospect theory, was identified and named by another Nobel Laureate, Richard Thaler, in 1988. It describes the process whereby people have different ‘mental bank accounts’ for different expenditures. For example, people tend to have a greater willingness to pay for goods using a credit card than cash, even though they draw upon the same resource. Similar to prospect theory, people are unable to focus on the final wealth outcome, instead considering the individual transactions separately and once again focusing on the path of returns.

Diminishing marginal returns

Utility theory and prospect theory appear similar in that as wealth or gains increase (utility theory is focused on total wealth and prospect theory on relative gains versus a starting point), the marginal value or utility progressively declines. In other words, the joy felt from a $1000 investment moving up to $1010 is less than the joy felt from a $100 investment moving up to $110. The absolute gain is the same, but clearly we value relative gains differently to absolute gains.

What does this mean for retirement planning?

We believe a sound understanding of prospect theory can assist advisers and investors design better real-world portfolios that more closely align our humanistic behavioural biases with the path of asset class returns – and ultimately, investment outcomes.

It seems like common sense when markets are calm, but integral to a financial strategy delivering the benefits and outcomes it was designed for is the investor ‘staying the course’ and remaining invested with a consistent long-term strategy. By recognising the pull of our emotional magnets and incorporating these into a comprehensive investment plan, advisers can add value by increasing the likelihood that their clients stick to their long-term plans.

Based on this, it makes sense for investor portfolios to address the following three key criteria.

1. Loss aversion (via capital protection)

Losses are felt more acutely than gains, and – as the GFC proved – retirees are more likely to disinvest during market stresses (i.e. precisely the wrong time) than other age groups. This behavioural bias during drawdowns is compounded by the separate concept of sequencing risk, which can also serve to materially impair outcomes for retirees.

As such, capital protection is integral during periods of market weakness. Note that this usually only comes at some cost of foregone investment returns (i.e. without risk there can be no return), and hence some approaches to capital protection can perversely increase risk as they simply increase the certainty of investment returns not delivering a portfolio’s objective. The key is to improve the shape of returns to minimise drawdowns – delivering a growth profile with capital protection.

2. Certainty effect (via higher income)

Investors value more certain returns above more ambiguous returns. In an equity landscape, we believe this helps explain the typical Australian retail investor’s focus on distributions, where regular bank account deposits can unfortunately be prized more highly than the accompanying capital fluctuations in the unit price. While there may be some comfort provided to retirees from regular payments, the more important metric is ‘total return’, which includes movements in the unit or share price alongside distributions.

Within this total return focus, income can play a critical role by providing:

  • greater certainty, especially in low growth environments when real returns are difficult to generate, and
  • increased predictability, as the range of possible investment outcomes can be narrowed.

3. Diminishing marginal returns (via a smoother return profile)

As above, an investor’s sense of value diminishes as gains increase, so a gain from $100 to $110 is less meaningful than a gain from $50 to $60. In this way, underperformance in a strong positive market is less important to an investor’s sense of value, especially in relation to stronger performance in a lower growth or negative market.

Prospect theory provides a framework for how investment decisions are actually made in the real world, as opposed to how they should be made in terms of maximising outcomes. Kahneman touches on the evolutionary origins of these behaviours, and that the instinctive, reactionary impulses that served us well for millennia need to be recognised as being less-suited for investment portfolios!

The Wheelhouse approach

We recognise the unique investment challenges faced by Australians in retirement.

Retirees require growth for their savings to fund ever-lengthening life expectancies, so equities are an important part of their asset allocation decision. However, retirees need those equity returns delivered in a more ‘retiree-friendly’ shape that incorporates a higher component of income along with greater levels of capital preservation. This retiree-friendly shape is illustrated in the chart below and underpins our investment philosophy.

It’s no coincidence that our targeted return profile is very similar in shape to the value function observed in prospect theory. The below chart combines the two shapes.

  • Capital protection – our strategy steadily reduces risk the more the market drops, preserving capital more aggressively the sharper the fall.
  • Income generation – income accounts for approximately two thirds of our total equity return, increasing consistency and certainty – especially in low-return environments where it can be a source of real return (e.g. around 0).
  • Acceptance of drag in strong markets – our return profile is consistent with behavioural tendencies being more accepting of underperformance in strong markets.

Proof of concept

The following chart illustrates the daily returns of the Wheelhouse Global Equity Income Fund versus the underlying equity portfolio, which is representative of typical equity market returns. Data points above the orange line represent outperformance and below the line represent underperformance, and the targeted ‘retiree-friendly’ return profile is self-evident.

Net returns are available on our website, wheelhouse-partners.com



Prospect theory is the bedrock of modern behavioural finance, particularly as it applies to our investment decision-making.

Unfortunately, as humans our ‘emotional magnets’ can wreak havoc with rational decision-making, particularly in times of a crisis. Long-term, well-crafted investment plans can turn into ‘impatient capital’ overnight, with damaging consequences. John Maynard Keynes is famously quoted as saying, “When the facts change, I change my mind.” Evidence suggests that retirees are particularly at risk of acting against their best financial interests at the worst possible times.

We believe retirement portfolios that are constructed to deliver growth, but with a return profile that mirrors our humanistic biases and includes elements of loss aversion and income certainty, can result in an increased likelihood of adhering to long-term plans and thus achieving better outcomes.

From an adviser’s perspective, it should also be noted that this less stressful investment path may lead to a more rewarding and fulfilling client relationship – which is in everyone’s best interest.

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