The "Grandfather" of Behavioural Economics

In late March, psychologist and economist, Daniel Kahneman, passed away at the age of 90. His work with Amos Tversky and others helped to establish the field of behavioural economics, including explaining cognitive biases and heuristics, and developing Prospect Theory. In 2002, Kahneman was awarded the Nobel Memorial Prize in Economics "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty". Kahneman also wrote best-selling books including Thinking, Fast and Slow.

Kahneman's insights in the world of trading highlight biases such as overconfidence, herding behaviour, and loss aversion. His work is highly relevant for trend following managers, whose quantitative systems seek to exploit market inefficiencies. In this article, we provide a brief taste of some of Kahneman's work and how trend following is consistent with his elucidation of human behaviour.

The Reflection Effect

One aspect of Kahneman & Tversky's seminal Prospect Theory is the Reflection Effect, which describes how people's appetite for risk changes when we think about the same decision focusing on gains or focusing on losses. Kahneman and Tversky demonstrated that people are risk averse in the domain of gains, and risk seeking in the domain of losses. For example:

• A positive "gamble": given the choice to take $900, or take a 90% chance to win $1,000 (mathematically the same outcomes), people will generally tend to take the $900. It can be explained through the lens of the psychological value of the certain outcome being worth more to people than the prospect of winning $1,000. That is, an extra $100 doesn't seem worth the risk of getting $0

• A negative "gamble": given the choice of losing $900, or take a 90% chance to lose $1,000 (mathematically the same outcomes), people will generally tend to take the chance. Here we see the inverse (or reflection) of the positive gamble - the psychological value of potentially losing nothing is worth more than the risk of losing $1,000 instead of the $900. That is, the additional $100 loss doesn't seem to outweigh the potential positive of losing $0

That is, people will tend to take a risk to avoid losses, and will avoid risks to lock in gains. They will even make different decisions based on how a problem is framed.

There are studies around breakeven effects which further show risk seeking in the domain of losses. Experiments were conducted where people were studied at horse tracks, and found that punters placed riskier bets (longer odds) towards the end of the day, when they were on average already making losses - that is, they tried to win back their losses to break even. We can see this effect in force when investors hold on to losing stock market trades, hoping they will go back up to break even, or even take on riskier trades to try to win back losses.

Trend following systems are designed to overcome the Reflection Effect. Where human psychology instinctively has us locking in gains, trend following systems let profits run. When human psychology tends to steer us to take bigger risks to avoid losses, trend following systems are designed to limit losses through consistent and unemotional stop loss levels.

Emotions vs Rationality in Markets

Although those of us who are schooled in the field of Finance are taught the Efficient Market Hypothesis - that asset prices reflect all available information, behavioural economics highlights the role of emotions in decision making. Cognitive biases such as overconfidence, herding, information bias and loss aversion may help to explain market bubbles / "irrational exuberance" as well as "over-reactions" contributing to market crashes.

For example, Kahneman and Tversky found that people will typically extrapolate broadly from narrow data sets, which they called the Law of Small Numbers. To illustrate this effect, consider:

• tossing a coin three times to find it lands on heads each time - one might extrapolate that it is more likely to land on heads in the future, but

• tossing a coin a very large number of times shows us that overall the odds are 50/50 of a heads or tails result.

We can see that this cognitive bias may result in flawed decision making, and irrational market behaviours.

Trend following systems are designed to attempt to exploit irrational market conditions, and to avoid cognitive biases through systematic approaches to trading. Our strategies at ECCM are tested over long term, deep and broad data sets to avoid information biases and enhance objectivity.

At our website and our YouTube channel you can view our video "Embracing Objectivity Through Systematic Trading", in which ECCM's founder and CIO, Adam Havryliv, and Strategy Ambassador, Richard Brennan, talk more about our approach to statistical analysis and how we seek to avoid cognitive biases. 

Conclusion

Daniel Kahneman and his colleagues developed highly influential and insightful studies which have helped to explain human behaviour and in turn market dynamics. We recognise his work and the impact he had on our understanding of financial markets.

At ECCM, our educational foundations are in finance and psychology. With extensive trading experience and long-term dedication to quantitative trading systems, we seek to provide our clients with our carefully developed approach to navigating the complexities and vagaries of markets.

Wholesale clients can find more information on ECCM and our flagship ECCM Systematic Trend Fund at our website and Australian Fund Monitors.

Travel and holidays are important to many people as they represent a break from the norm, a chance to escape mundane reality and experience something exciting and possibly exotic. They are a chance to reconnect with family and friends away from the stresses of daily life and can provide significant benefits for our physical, mental and emotional health.

The forced lockdowns imposed during the pandemic era reinforced the value of holidays for many of us, and in our view there has been a meaningful shift toward experiences that cuts across generations. So much so that in a time when the cost of living has risen dramatically, rather than cutting back on holidays people continue prioritising their importance.

Having normalised significantly during 2023, international tourism is well on track to return to pre-pandemic levels in 2024, underlining why we feel this ongoing Future Quality investment trend is still worth pursuing.

Successful recovery of global travel

For the last couple of years, the global travel industry has been going through the process of normalisation following the pandemic-imposed restrictions that brought worldwide travel to a halt. Planes were grounded, accommodation closed and staff were laid off or siloed; consequently, the sector's recovery has taken time to rebuild to its former scale.

This normalisation has taken place against a backdrop of strong consumer demand. As lockdown restrictions were lifted, many consumers were eager to rebook holidays that had been either cancelled or postponed. The unleashing of this pent-up demand meant that, according to the UNWTO World Tourism Barometer, international tourism reached 88% of pre-pandemic levels in 2023.

As investors, we were quick to spot the investment opportunity that the normalisation of travel would represent. But now the recovery appears to be almost complete, it is time to reconsider the ongoing strength of this investment theme.

Ongoing growth drivers

Our analysis has determined that there remain several key ongoing drivers of growth for the travel industry. Firstly, while the market expectation that demand has now normalised seems fair, we found that one key factor is largely being ignored: the re-emergence of the Chinese outbound traveller. COVID-19 lockdowns were in place for a lot longer in China than anywhere else in the world and therefore travel restrictions have only just been fully lifted. Given the significant size of the Chinese population, the process of restoring the operational outbound capacity for flights will take time to reach its former scale and demand was initially subdued amid lingering concerns over COVID-19 and tepid economic growth. Yet, the importance of Chinese travellers should not be underestimated. In 2019, they represented the world's largest share of outbound tourists, contributing around US$250 billion to the global economy. Signs are positive that Chinese travel will rebound this year, with domestic trips over the China Lunar New Year holidays increasing 34% compared with 2023 and marking a 19% rise on 2019 levels. Travel and tourism have also been highlighted as the best-performing elements of China's otherwise lacklustre economy.

Chart 1 - Number of outbound Chinese tourists (in millions) 

Source: Bloomberg, April 2024.

Secondly, a new travel cohort is emerging from developing countries - India as a prime example - where rising gross domestic product per capita means more people will be able to afford to travel in the future. While this also includes China, it particularly encompasses the wider Asian region and has resulted in UK airport Heathrow increasing its forecasts of passenger numbers this year due to the growth in Asian routes.

Finally, artificial intelligence (AI) is being embraced by the travel industry initially to enhance the booking experience for flights, accommodation and car hire, as well as boosting call centre efficiency. However, going forward, AI applications could encompass advertising strategy, marketing content and greater personalisation.

Another factor to consider is supply and demand. Given that the demand is clearly there, it would be expected that at this stage of the cycle new accommodation would be being developed at an aggressive rate. However, due to concerns around commercial real estate and higher borrowing costs, that supply growth is not coming through, and is creating further inflationary pressures on overall holiday prices.

Future Quality Finders

Having discussed and reviewed our investment thesis around global travel, we still need to apply our Future Quality lens to find the companies that will attain and sustain rewarding returns not only today but, more importantly, for tomorrow.

In our view, many quality companies are directly benefitting from the positive tailwinds in global travel, from booking companies to manufacturers of luggage and travel accessories. We currently favour Booking.com, Amadeus and Samsonite.

Focusing on luggage manufacturer Samsonite, having re-engineered its manufacturing footprint and streamlined its costs during the pandemic, we felt its management did a good job of positioning the company for more profitable growth in the future with brand equity and pricing power largely intact. We expect the ongoing recovery in travel, particularly among business travellers, will continue to drive revenue growth and, with a lower fixed cost structure, the business has the opportunity to earn margins somewhat higher than the traditional norm.

By seeing further and envisioning the investment opportunities of tomorrow, we aim to invest in not only what is, but what will be. Contrary to popular perceptions, we anticipate that global travel will endure as a long-haul investment journey.