Loss Aversion: How it Impacts Your Investments

Loss Aversion: How it Impacts Your Investments

I recently finished reading Thinking Fast and Slow by Nobel Prize winner in economics Daniel Kahneman. It was a very interesting read on how our brain works and many of its biases, along with how to avoid/cope with them. The one I thought was incredibly relevant for our clients is loss aversion.
In essence, what loss aversion bias describes is that we are genetically hardwired to feel loss twice as much as we feel gain. Think of going to a casino and how annoyed you get losing $100 versus the mild excitement you get from winning the same amount. Loss aversion has been well documented and studied in the sociology and behavioral economics field for some time now.

Loss Aversion Bias

The question is how can we utilize this knowledge of the loss aversion bias to improve our investment performance? Let’s start by understanding some basic stock market statistics to better grasp things. Historically speaking, the stock market is up 3 out of every 4 years (or 75% of the time), and 55% of trading days the stock market is up.

Before we dive into the suggestions, from Daniel Kahneman, we should analyze the above stock market statistics for a moment. I find it very interesting that if you look back at the history of the stock market you will have up years approximately 75% of the time or 3 out of every 4 years (70% of quarters end positively as well, more on that in a moment). To me, that is very comforting to know that for every bad year, I should expect 3 great ones. I think we would all sign up for that. More interestingly is that it manages to do that when 45% of the days are negative trading days. So interesting to me that although most years the market is up, most days it is virtually a coin flip to see if the stock market will be up or down.

Further analyzing this and looping in loss aversion bias, this means that roughly half the days you feel terrible and half the days you are happy (ask my mom). Now if we couple that fact with the loss aversion that means that you are virtually always upset, being that you feel pain 2 for 1 when compared against pleasure. Said differently, if the markets are up only about half the days it will feel to you pain-wise that they are up only about 1/3 of the time and down 2/3 of the time.
What does Daniel suggest?

I’ve written about this exact topic before, but now that I have a Nobel laureate backing me, I’ll use his much more articulate words to describe it.

“The combination of loss aversion and narrow framing is a costly curse. Individual investors can avoid that curse, achieving the emotional benefits of broad framing while also saving time and agony, by reducing the frequency with which they check how well their investments are doing. Closely following daily fluctuations is a losing proposition, because the pain of the frequent small losses exceeds the pleasure of the equally frequent small gains. Once a quarter is enough, and may be more than enough for the deliberate avoidance of exposure to short-term outcomes improves the quality of both decisions and outcomes.”

Simply put, if you look at your investments daily, it will add a heavy layer of stress and loss aversion to your psyche. Rather, if you adjust your frequency down, it will move your mental state up. More importantly, the net effect is that you are more likely not to make emotional decisions about your investments and let the statistics work in your favor.

Real-Life Experience

As someone who has been advising clients on their investments and financial health for way too long I could not agree more with Mr. Kahneman. The clients of mine who look at their investments less seem to have a better experience and more enjoyment all around. They are less likely to make jittery moves, and more importantly, they are more likely to simply enjoy their lives and finances more.

The suggestions may not be a panacea for everyone, but why not give it a try especially if you find yourself falling into this loss aversion trap? Remember these things are hardwired into our caveman brains so it is very hard to simply rewire ourselves naturally. Biases are biases for a reason and any way we can combat them should certainly be considered.

Thanks for listening and as always stay wealthy, healthy, and happy!