Product Design in Behavioral Finance
Chapter 7 of “Behavioral Finance for Private Banking” is about structured products. If you’ve never heard of them, don’t worry. Most people haven’t. But by the end of 2007, there were more than 340 billion Swiss francs invested in them in Switzerland alone. That’s 6.5% of all assets under management. Over 20,000 different structured products listed on the Swiss stock exchange.
So what are these things? And why does behavioral finance care about them?
What Are Structured Products?
In simple terms, a structured product is a financial instrument built from simpler pieces. Usually a bond plus some options. The idea is to create a custom payoff shape that you can’t get from just buying stocks or bonds alone.
From traditional finance point of view, you don’t need structured products at all. The theory says: buy the market portfolio (like an ETF), add some risk-free bonds, and you’re done. The mix depends on your risk tolerance. That’s it.
But here’s the thing. Traditional theory assumes your payoff diagram is always a straight line. More risk, more return, less risk, less return. Linear.
Real people don’t think in straight lines. They want capital protection (don’t lose my money!), caps (I’m ok not getting the maximum upside), and changing levels of participation in gains. Structured products can shape all of that.
The Ladder Pop: A Case Study
The authors look at a real product called the “Ladder Pop” that was sold in Switzerland. It tracked the Swiss Market Index (SMI) over about 5 years starting in 2002. The minimum investment was 5,000 CHF.
Here is what it offered:
- A floor of 80%. At maturity, you get at least 80% of your money back. So the maximum you can lose is 20%.
- Participation in upside. If the market goes up, you get some of the gains.
- A “ladder” feature. The product tracks the highest level the market reaches during the entire period. Every time the market goes up another 10%, a new “level” locks in. You get half of that maximum level, even if the market drops back down later.
Sounds pretty clever, right? You get downside protection AND you capture some of the peaks.
But here’s the problem. The actual investors who bought this thing in January 2002 didn’t do so well. During the first year the SMI dropped 40%, and the Ladder Pop limited losses to about 21%. Good. But over the full 5 years, a simple buy-and-hold strategy returned 38.2%. The Ladder Pop investors? They got only 18.2% because of that 20% they paid for the protection.
They paid for insurance they didn’t end up needing.
Does the Bank Make Money?
Yes. Obviously.
The authors show a simple calculation. The bank can hedge the product using stocks and bonds for about 97.86 per 100 units of the product. They sell it for 100. That’s a 2.14% profit margin, risk-free, built right in.
This is important to understand. The bank is not taking a bet on the market. They hedge the risk completely. The profit comes from the spread between the product price and the hedging cost.
Who Actually Benefits from Structured Products?
This is where it gets interesting. The authors test whether different types of investors would prefer the Ladder Pop over just buying stocks or bonds directly.
Traditional Investors (Expected Utility)
For a standard risk-averse investor using classical utility theory, the answer is clear: no. These investors would always prefer to buy either the stock market directly or bonds. The Ladder Pop is never the best choice. Not at any level of risk aversion.
Prospect Theory Investors (Loss-Averse)
Now here’s where behavioral finance changes the picture. Remember prospect theory from the previous chapter? People hate losses more than they enjoy equivalent gains. They use reference points. They weigh probabilities differently.
For a prospect theory investor who compares the structured product only to stocks (not to bonds), the Ladder Pop suddenly looks attractive. Why? Because it protects them during the bad times.
The key insight: if an investor can’t stand losing more than 25%, the Ladder Pop is actually the best choice. With the Ladder Pop, the investor holds through the rough period and ends up with a 15% gain. With just stocks, the same investor panics at a 25% loss and sells at the bottom. The bond gives only 10%.
Loss-averse investors don’t need the mathematically optimal product. They need a product they can actually hold through a market crash.
Designing the Optimal Product
The authors then ask: if we could design the perfect structured product for each type of investor, what would it look like?
For standard risk-averse investors (CRRA utility), the optimal payoff is a smooth curve. Some capital protection, increasing participation in gains. Nothing dramatic.
For mean-variance investors (the textbook case), the optimal product is just a straight line. Which is basically a mix of stocks and bonds. No structured product needed.
For loss-averse investors, the optimal product has strong capital protection on the downside. The more loss-averse you are, the stronger the protection should be. These investors willingly give up some upside to avoid seeing red numbers.
For probability-weighting investors (people who overweight small probabilities), the optimal product looks weird. It has high payoffs in extreme scenarios, both up and down, and lower payoffs in the middle. These investors are essentially buying lottery tickets combined with insurance.
The Problem with Popular Products
Here is where the chapter gets a bit uncomfortable for the industry.
The most popular structured product in Switzerland was the barrier reverse convertible. It pays a nice coupon (like a bond). And you get your money back at maturity, unless the underlying drops below a certain barrier at any point. If it does, you’re stuck with the losses.
Researchers found something concerning. Investors buy these products because they underestimate the probability that the barrier will be hit. They see the nice coupon, they see “you get your money back unless this unlikely thing happens,” and they think it won’t happen.
It gets worse with “worst-of-basket” products. These track multiple assets, and the payoff depends on the worst performer. Investors actually estimate that the probability of hitting the barrier with multiple assets is lower than with a single asset. That’s backwards. More assets means more chances for one of them to crash.
People buy these products because they don’t understand the math. That’s not behavioral finance working as designed. That’s just confusion being profitable.
When Customers Design Their Own Products
The University of Zurich ran a fascinating experiment. They built an interactive touchscreen table where people could design their own structured products. Move the payoff curve up in one area, and the system automatically adjusts other areas to keep the cost the same. You learn by doing.
Over 600 people tried it at a public exhibition. What did most of them design?
Capital protected products. With or without a cap on the upside.
The average product people designed looked like a covered call strategy. Protection on the downside, participation in moderate gains, limited upside. That’s exactly what prospect theory predicts loss-averse investors would want.
My Take
This chapter is honestly a bit math-heavy in the original text. But the core message is simple and important.
Traditional finance says structured products are unnecessary. Just buy stocks and bonds in the right proportion. Mathematically, that’s correct.
But people are not math equations. Loss-averse investors need products they can actually hold when markets crash. A mathematically inferior product that keeps you invested beats a mathematically perfect portfolio you panic-sell out of.
The real problem is when the industry uses behavioral biases against investors. Selling complicated products that look good because people can’t estimate probabilities correctly. That’s not serving client needs. That’s exploiting client weaknesses.
The line between helpful product design and harmful product marketing is thin. And it runs right through behavioral finance.