The Dieter’s Paradox: When Adding More Risks Feels Safer

Nov 17, 2022 | Markets

Take a portfolio made 100% of Moderna shares. Take a second portfolio made of Moderna shares and Nestlé shares. The second portfolio will look safer to probably everyone and correctly so: that’s what diversification is about. Mixing a safe stock to a risky stocks makes the overall portfolio less volatile.

Barrier Reverse Convertible example

 Now take a Barrier Reverse Convertible 70% Barrier, 5% coupon on Moderna. Also take the same BRC on the worst of Nestlé and Moderna (same coupon, same barrier, offered at the same price). Surprisingly, most people would rather invest in the BRC on the worst of Nestlé and Moderna than the BRC on Moderna alone (once again same barrier, same coupon, for the same price). That is obviously irrational as in a worst of structure risks add up and do not mitigate (how many times have I heard clients talking about diversification when adding underlyers in worst of structures…).

 That phenomenon has been studied by Kunz, Messner and Wallmeier (2017) and Hanaki (2022) in the Journal of Behavioral and Experimental Finance. It is known as the “dieter’s paradox”: people on diet tend to think that after eating junk food, eating something healthy could have some negative calorie effect. In the same fashion, adding a safe stock to a worst of structure would reduce the overall risk of the structure. Both papers show that the behavioral bias is very pronounced amongst retail/inexperienced investors. Using CFA holders, Hanaki shows that well educated investors are not subject to that bias.

 References:

Kunz, A. H., Messner, C., & Wallmeier, M. (2017). Investors’ risk perceptions of structured financial products with worst-of payout characteristics. Journal of Behavioral and Experimental Finance15, 66-73.

Hanaki, N. (2022). Risk misperceptions of structured financial products with worst-of payout characteristics revisited. Journal of Behavioral and Experimental Finance33, 100604.

 

 

 

 

 

 

 

Eric Barthe

Eric Barthe

Founder of Structuredproducts.net

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