“Prospect Theory” and Brexit

“Prospect theory” was first formulated in the late 70s’ and in a nutshell it assumes that gains and losses are valued differently and hence individual investors make decisions on perceived gains rather than perceived losses. It is also sometimes known as “loss aversion” theory.

The theory proposes that losses have a greater emotional impact on investors than an equivalent amount of gain. I looked at the maths behind all this and pretty soon I found myself in deep trouble, so I decided to make the assumption that the calculations all stack up and focus just on the theory.

The point about this is that when faced with two choices, an investor will almost always opt to avoid risk where certainty of a gain is attached. In the trading sense I guess we would call that ‘locking in a profit.’

However, when it comes to the pound and Brexit over the past couple of years’ the application of this theory has taken on a slightly different form; the fear of being exposed to significant risk without even necessarily locking in a gain at all. That notion has been the driving force behind the pound’s weakness. This has resulted in a huge amount of GBP selling as a hedge against the perceived worst case scenario.

Indeed, this whole notion of a fear of losing out was at the very core of the remain camp argument- ‘if we leave we’ll be much worse off’ etc. Now of course that argument will never ever be tested unless we do actually leave and find out for ourselves. Further to that would be the basis on which we do actually leave, rather than the departure itself perhaps. From a personal perspective this has led me to a feeling of utter consternation over the never ending politics surrounding it all- its probably driving everyone else to distraction too.

I fully concede that I have been very much in the camp that there will be something to lose by leaving the EU, but for the most part that has been confined to the exchange rate and little else quite honestly.

Now, to the man on the street that aspect might not seem to matter much, but if the pound collapses there is much to be gained or lost beyond the immediately obvious- more expensive imports and vastly more competitive export prices. Even then, complicated global supply chains these days have made that assumption very much a grey area anyway.

Putting the trade impact to one side, take for example overseas based investors with significant UK property assets. I know some of those have been actively selling the pound since 2016 as a hedge against their UK holdings- in fact probably the only effective way for them to hedge as one cannot simply offload vast swathes of real estate at the press of a button.  

Then there’s the UK based holders (and or potential buyers) of overseas property looking to hedge or either buy now before it gets even more expensive due to a further fall in the pound. Let’s not forget that it’s already significantly more expensive to buy a pad in Europe and more so in the US, in sterling terms since 2016.   Conversely, existing UK based owners of foreign property would be faced with an immediate windfall should the pound collapse. So, its by no means one-way traffic when it comes to the pound’s ultimate destination. Like in most things financial there will be winners and losers.

Indeed, the list varying interests both ways, is so long that I won’t even attempt to note them here, but in many cases there’s surely a measure of that ‘prospect theory’ coming into play.

What is interesting as we get closer to the end game on all this is just how pivotal the current price is on the GBPUSD. This is well demonstrated when we take the official 2016 low at 1.1841 and the high earlier this year at 1.4377 and calculate the mid point between the two-  it comes out at 1.3109.

Strangely enough as I start to write this article around 11am yesterday that’s exactly, and I mean exactly, where the price was. Now of course, that may well change by the time you come to read this (in fact it is lower this morning), but not by that much in real terms. Now you might think that me telling you that the pound is slap bang in the middle of where it has been since Brexit hardly constitutes earth shattering news.

That as maybe, but as you can see the price of the GBPUSD is highly pivotal right now. The red line which I have drawn on the chart marks that 1.3109 mid point. However, this does tell me one thing. Current professional positioning is probably pretty neutral and hence far better poised to jump one way or the other than its has been for some time. I think we can probably thank the options market for that with so many players now surrounding the market both sides of the fence.

Irrespective of that and from my own ‘prospect theory’ point of view I still favour the downside, but as I said earlier in the week, the current price is already well below fair value.

From a purely technical perspective that fair value might yet still come into play if the price starts to break back above 1.35. All the time it doesn’t though, then the ‘prospect’ of another lurch lower is very much the risk as far as I am concerned.

Finally, and very briefly; elsewhere the dollar has rebounded since yesterday and now the EURUSD is creeping ever closer to a key support level at 1.13- a level which if decisively broken could open a path towards 1.10.