Written by Adrian Meager, General Manager of Asset Management, Warwick Wealth
In economics, loss aversion refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains: it’s better to not lose R100 than to find R100. Some studies have suggested that losses are more than twice as powerful, psychologically, as gains. This theory was formulated in 1979 and further developed in 1992 by Amos Tversky and Daniel Kahneman.
Even with a brilliant investment plan, it takes diligence to overcome our emotional biases and avoid making investing mistakes. Here is some of the wisdom that investors should bear in mind to avoid succumbing to the fallacies of behavioral economics.
It doesn’t take extensive research to determine that we are much happier when our portfolio values go up. When they go down even slightly, however, we are tempted to make poor choices. To avoid these unfortunate choices, we need reassurance and a sense of how our instincts can deceive us.
The tendency to experience significantly more discomfort with slight losses than to experience happiness with large gains is called ‘loss aversion.’ To illustrate this, consider a coin-toss where you could either accept R100 or face 50-50 odds on winning R250 or nothing at all. Most people would take the R100.
Psychologists suggest we feel a loss about 2.5 times as much as the equivalent gain. That means if you see an equal number of ups and downs, you feel miserable. You feel some pleasure when the markets move up and a great deal of discomfort when the markets move down.
Therefore, the more frequently you look at the markets, such as daily or weekly, the more discouraged you may get. Even with a well-crafted investment strategy, you may be tempted to make changes in order to alleviate your suffering. When we base our investments on emotions, we make bad decisions, these decisions can lead to losses. A nervous investor may liquidate their investment portfolio and invest into a money market account, attempting to time getting back into the market, causing each investment decision to become more and more stressful. Almost all studies show that loss aversion actually causes greater than average losses.
Consider that over the past decade, the daily movement in the markets was positive approximately 52% of the time. That means if you watched the markets every day, you were content on 190 days and despondent on 175 days. Because you feel distressed on the down days 2.5 times more than you celebrate the positive ones, instead of remembering the reality that the markets moves down only 48% of the time, you feel as if goes down 70% of the time.
This is not to suggest that you neglect your investments by any means. You still need to periodically track your performance, make sure your asset allocation is in line with your risk profile and rebalance your portfolio. Indeed, with the ease of access to real-time information these days, it is very hard not to look at the market.
A study by Thaler, Schwarz, Kahneman, and Tversky in the 1997 Quarterly Journal of Economics found that investors who received the most frequent short-term information took the least risk and grew their portfolios the least. This situation, known as myopic loss aversion, challenges perceived opinion about how much communication advisers should have with their clients — more isn’t always better. The ‘less is more’ philosophy seems to work in almost all areas of the portfolio management process. Checking the value of your investment is no different in this respect. Remember, as you lengthen your time horizon, the effects of loss aversion slowly start to fade.