Normal Investors - Loss Aversion

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As I mentioned a couple of weeks ago, I'm now going to do a series of posts on what makes normal investors “normal.” You see, a vast majority of traditional investment theory is based on the assumption that all investors are always rational. Essentially the people who completely believe in the Efficient Market Hypothesis believe that if investors have access to enough information, they will always act rationally and choose the investment portfolio best suited to their needs. They also believe that if investors always act rationally, then the market will always behave rationally. Maybe it’s me, but I don’t feel like the market always behaves rationally, and neither do some other very smart people.

In 1956, Mr. Vernon Smith introduced the concept of behavioral finance. In the 1960s, psychologist Mr. Peter Slovic began analyzing investor’s behavioral biases. In 1974, psychologists Mr. Amos Tversky and Mr. Daniel Kahneman introduced heuristics - the study of how people make decisions or solve problems, often using their experiences and biases. Since then, academics, brokers, and financial advisors have continued to try to understand the difference between a “completely rational investor” and the actions a lot of people take when investing their own money. Behavioral finance attempts to explain the difference between what traditional investment theory says should happen in the market and actual market behavior. Please don’t get me wrong, behavioral finance does not assume that investors are irrational; it assumes investors are normal human beings. I find behavioral finance to be a fascinating field of study that helps me better understand my clients, and that’s why I’d like to share five biases many normal investors seem to have, beginning with loss aversion.

1. Let’s pretend you’re on a game show, and I’m the host. I’ve given you $1,000. You have two choices: A) you can choose to walk away with a sure gain of an additional $500, or B) you can choose to take your chances with the flip of a coin. Heads, you’ll gain another $1,000. Tails, you’ll gain nothing. What do you choose A or B?
2. Alright, let’s once again pretend you’re on a game show, and I’m the host. I’ve given you $2,000 this time. You have two choices: A) you can chose to walk away with a sure loss of $500, or B) you can choose to take your chances with the flip of a coin. Heads, you’ll lose nothing. Tails, you’ll lose $1,000. What do you choose A or B?

Now if you are a completely rational person trying to do what is in your best interest, wouldn’t you choose A both times and walk away with $1,500? I mean, if you choose B in either example, you could end up walking away with only $1,000 when you could have had $1,500 by simply choosing A with no coin flip involved whatsoever. What if I told you these two questions were real questions from a study written by Tversky and Kahneman, and the results of the study showed most people chose A for the first example, but most people chose B for the second one? Why would anyone do that? Because of the way the questions are worded! I, and many people who have conducted similar studies, would submit because people are willing to do anything to avoid the pain of loss. Some call this phenomenon the Prospect Theory and quantitatively suggest that losses are twice as painful to investors as gains are pleasurable. Shown on a graph, this might look like:

 

 

 

This loss aversion associated with many investors is financially dangerous because it can lead people to sell profitable investments too early (because they don’t want to lose their modest gains) and unprofitable investments too late (because they don’t want to actually recognize their losses, and they’d rather keep hoping they can regain their initial investment than acknowledge what has happened). Coupled with our nation’s unfavorable capital gain taxes on profitable investments that are sold that were held for less than a year, and you could have a double whammy!

 

I can tell you from my experiences fielding calls and replying to emails over the past couple of volatile weeks in the market, a 2% daily loss is not equal to a 2% daily gain in the eyes of some investors. Maybe it should be, but it’s not. I even had a gentleman on one of those days where the market was down a few percentage points apologetically acknowledge that he knew he didn’t call me when the market was up 2% in one day. We shared a laugh, and I told him I’d call him the next time it was up 2%. I can’t blame him though, he’s just being a normal investor who has a double aversion for loss.

 

-Tom

 

Next up: overreaction and underreaction.