Loss Aversion And The Impact Of Daily P&L

Managers often find their mood is heavily swayed by the daily vicissitudes of P&L. Bad days can wreak havoc on the psyche, and good days can just leave you relieved that you didn’t have a bad day. Why is this?
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In a nutshell, the pain of loss far outweighs the pleasure from gain. This is the key takeaway of Kahneman and Tversky’s 1979 “Prospect Theory” paper. There are dozens of follow-on Prospect Theory articles, and after a quick Google search, it looks like, in general, a loss feels 1.5x to 2.5x worse than an equivalent gain feels good.
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There are 252 trading days in a year. Let’s assume you make money 150 of those days for a stellar daily P&L batting average of 59%. If the pain of a loss is 2x greater than a gain, you will end up with 204 units of pain (102 loss days x 2 units of pain) and 150 units of pleasure. A 59% batting average, and you still end up feeling bad. Not bad in the sense that you’re disappointed by the year but bad in the sense that the daily P&L had an eroding effect on your psyche.
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For fund managers, the wear and tear of daily P&L is one of their biggest mental challenges. One solution is to just stop looking at daily P&L. This path can be liberating, but the pushback is that a portfolio manager must “know” their portfolio, and to do so, they must look at daily P&L (or, even worse, real-time P&L).
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The logic for monitoring daily P&L is that it is a real-time feedback mechanism providing a portfolio manager with information about the quality of their decisions. If something is going wrong, the negative P&L can be the canary in the coal mine. The problem is that it can also give you false information. Daily P&L can lead to short-term reactive decision-making that contradicts their long-term investor skillset.
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The amount of signal in the noise is a good proxy for the value of looking at daily P&L. At Alpha Theory, we have found that fundamental investors possess skill in stock (Idiosyncratic) and industry selection. They possess little to no skill in timing markets and style factors (Growth, Value, Momentum, etc.). We’ve found that about 70% of the risk in long-short portfolios comes from those factors where they possess little to no long-term skill, with only 30% coming from stock and industry selection. Using this simple metric, the daily P&L is 30% signal and 70% noise. Too much noise to be a great feedback tool.
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When you think about your own experience, does this ring true? How often have you looked at daily P&L and said, “I can’t believe we’re down today. Nothing has fundamentally changed”? This makes daily P&L a poor feedback tool.
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A system with a good feedback tool is one where actions and results are highly correlated. Daily P&L is not a good one. By contrast, basketball is a good feedback tool. If you score a basket, you get +2 points. If you let your opponent score, they get 2 points (-2 change in your advantage). This is a perfectly correlated feedback system. But now imagine Crazy Basketball. In this game, the reward system is constantly changing, and you don’t know the current rule, but you do know that, over time, the mean return for a basket is +2. Currently, the unknown basket rule is to assign a basket value from a uniform range between -2 and +6 (mean is +2). With these rules, you could have a situation where you score a basket and get –2, and your opponent scores, and you get +2. This single observation would lead you to believe that you should not score baskets and you should let your opponent score. In Crazy Basketball and the market, short-term rewards are unpredictable. Over time though, with more observations, you would discover the rules that making baskets and picking fundamentally underpriced securities is good.
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So, what do we do about the poor feedback from daily P&L to save our sanity?
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- Control Daily P&L. Think about your own relationship with daily  P&L. Does it cause you to be reactive? Is it healthy for your psyche? Could a member of your team be in charge of letting you know when there are P&L changes that you need to address?

- Remove the Noise. There are tools (risk models – Alpha Theory has a partnership with Omega Point) that can help you isolate the stock and industry component of your returns. It is possible to hedge out the noisy risks and create a portfolio that is 80%+ signal.

- Isolate the Signal. Risk models break returns down into their component pieces. Each day, you can see how much return comes from Idiosyncratic, Industry, Market, Style, and Other factors (Alpha Theory clients can see this in the Daily Risk View report). When the portfolio gets whipped around by things you are not betting on (Market, Style, and Other factors), you will have a better understanding of how to respond.
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These changes should be a boon for a manager’s psyche. They also happen to align well with allocator trends. Allocators are increasingly reluctant to pay for market and factor exposure and are focused more on skill-driven return (stock and industry selection). This trend will continue as investors have inexpensive replacements for market and factor exposure. There is no cheap replacement for your skill.  
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In this industry, we have all chosen to play Crazy Basketball. Looking at the daily P&L scoreboard can lead to reactive decision-making and drain our emotional reserves. The reward system will always be volatile. Make your knowledge of this fact an advantage to adapt your process, actions, and, potentially, your business.