Knowing yourself is the beginning of all wisdom.
-- Aristotle (384-322 BC)
Aristotle understood how important it is for us to understand ourselves and how we think and process information. The more aware that we are of our own biases, the better decisions that we will make. Today, there is a whole field of study called “behavioral finance” that focuses on how people think about investing and money issues.
Many academic studies in behavioral finance have focused on how investors “feel” about losses in their portfolio. The studies show that losses tend to “hurt” investors more than corresponding gains make them feel good. In fact, most studies show that the pain endured by losses is about twice as bad for investors as the pleasure that they receive from similar gains. The term for this behavior is called “loss aversion.”
One place that the impact of loss aversion is demonstrated is with people who follow the stock market on a daily basis. The historical returns of the S&P 500 going back to 1950 show that, on a daily basis, the stock market goes up about half of the time and goes down about half of the time.* Basically, it is a flip of a coin each day whether the stock market is going to be positive or negative. However, for an investor experiencing the market’s daily ups and downs, they will feel about twice as bad when the markets go down as when the market goes up. This is certainly not a game worth playing!
Another issue where loss aversion is apparent in investor behavior relates to the decision to sell an underperforming investment. Let’s imagine for a moment that an investor bought shares of a company years ago at $10 per share. The stock price is now at $8 a share. The investor no longer likes the company, but doesn’t want to sell at this lower price. The investor says to himself, “Once the price hits $10, I’m selling!” Investors are often much more hesitant to realize losses than they would be to realize a gain in an investment. It is almost as if they are admitting that they made a mistake when they sell. However, it is often not in the best interest of the investor to approach investing in this way. In the example above, there is nothing to say that the stock will ever get back to $10 per share, and the better decision may be to realize the loss now and put the proceeds to work in more productive investments.
One effective way to deal with this behavioral issue is to reframe the problem in your mind. For example, I could say to the person above, “Let’s imagine that you instantly had the cash value of the stock that you currently hold. How much of the stock would you buy with that cash?” For most people, they would say “I wouldn’t buy any of the stock. I think it is a horrible company,” or something to that effect. The reframing of the issue puts the emphasis on the merits of the underlying investment and not on the specific price point that an investor has in their mind. This is the right focus for investing.
Anything that we can do to help avoid our own biases and focus our thought processes on the most important information is helpful. The more aware you are of common pitfalls, the better decisions that you will make as an investor.
* The actual percentages are that the stock market on a daily basis is up 53.7% and down 46.3%, but that it pretty close to 50/50!
Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as investment, tax or legal advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice.