Losses and Gains Are Not Equal!

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In economics and behavioral finance there is an idea called prospect theory. The idea is that most people seem to value losses and gains differently. Does the idea of losing $5,000 feel the same to you as gaining $5,000?

Some actually call prospect theory by a different name: loss aversion. This is because many studies seem to show that losses are about twice as psychologically impactful as gains. Now I’m no psychologist, but I must say, based on my experience in the financial industry, I tend to believe in this theory. When the Dow goes down 300 points in a day, I get more emails, more calls, and more app updates, and the stock market gets more coverage on the television and radio. When the Dow goes up 300 points in a day, I don’t get anywhere near the number of inquiries or hear anywhere near as much media coverage. Is this phenomenon because of fear? Is it because bad news sells? I don’t know, but I think it’s at least partially because of simple math.

Suppose you have $100,000 invested in the stock market and the next bear market hits and your portfolio goes down 30%. You’d be down $30,000 and your investments would now total $70,000. That would certainly stink, but a drop like that is by no means out of the question. Now what kind of bull market will you need to get your portfolio back to where it was? A 30% return? Wrong! You would need a return of 42.86% ($70,000 x 1.4286 = $100,000). Wait. It would take a 42.86% investment return to regain a $100,000 portfolio after the $100,000 portfolio was only down 30%? Precisely. Maybe losses aren’t always twice as mathematically impactful as gains, but losses are more impactful. I think this somewhat surprising and profound math may be part of the reason why losses are intuitively more impactful than gains.

A lot of people think all I do is manage investments. I manage a lot more than that. I manage goals, dreams, fears, and behavior. By having a proper financial plan and investment strategy in place that makes sure you have enough cash, bonds, and alternatives, you can withstand the downturns of the stock market. You can be positioned financially to have the confidence and courage not to sell your stocks low and permanently realize your temporary, paper losses. You can then wait for the next bull market to come, and when it does, when others are getting greedy and buying stocks high, you can rebalance your portfolio and recharge your cash, bonds, and alternatives so you will be prepared for the next market cycle.

I always tell my clients what I think is absolutely best for their unique financial strategy, but if anything, I must admit I err a little on the conservative side. It’s not that I’m chicken. It’s not that I’m pessimistic. I just know losses and gains are not equal psychologically, mathematically, or financially.

-Tom