22 Apr 2016

Understanding investor behaviour: loss aversion

Behavioural biases can wreak havoc in your portfolio. We explain loss aversion and what to look out for when it comes to this psychological bias.

Snapshot

  • Loss aversion is the human tendency to feel the pain of losses more than the pleasure of gains
  • Loss aversion can tempt you to sell investments at precisely the wrong time
  • If you spent a large part of January and February this year nervously eyeing your portfolio, use these calmer times to revisit whether your asset allocation is too aggressive.

Investing is as much psychology as it is mathematics, economics or accounting. Humans exhibit a number of behavioural biases that can leave an investment portfolio a lot worse off. Understanding these biases is important for long-term success.

There are some excellent resources available to aid your understanding. For example, a leading researcher in this field, Daniel Kahneman (a Nobel Laureate in economics) wrote ‘Thinking, Fast and Slow’, which explores the two systems that drive the way we think and make decisions. Richard Thaler and Cass Sunstein's ‘Nudge: Improving Decisions about Health, Wealth, and Happiness’ and Dan Ariely’s ‘Predictably Irrational: the Hidden Forces that Shape our Decisions’ are also worth reading. It is surprising how pervasive our behavioural biases can be in all facets of our life.

Examples of behavioural biases include overconfidence, herding (following the herd) and loss aversion. In this article, we’ll look at loss aversion and how it can wreak havoc in your portfolio.

What is loss aversion?

Individuals dislike losses much more than they like gains. Kahneman and Amos Tversky concluded (based on their research) that on average the pain of losing is twice as powerful as the pleasure of the equivalent gain. This is an average and some people will be more or less loss averse than others. In fact, Kahneman cites that professional financial market participants are more tolerant of losses and are less likely to respond emotionally to every fluctuation.

An example may help to illustrate this point. Imagine you’re offered the opportunity to gamble on a coin toss; ‘tails’ you win $150 and ‘heads’ you lose $100. Is this an attractive gamble and one you would be willing to take? Clearly, the expected gain is positive as you stand to win more than you lose, but interestingly most people prefer not to take this bet as the fear of losing the $100 outweighs the joy of winning $150. For many people losses simply loom a lot larger than gains[1].

Many investors still feel the pain of the losses incurred during the global financial crisis a lot more acutely than the joy of the gains we’ve experienced since 2009. In fact, the pain of losses made many investors want to sell down their portfolios after the market collapsed, and hold higher levels of cash and term deposits. But with the benefit of hindsight we can see that share markets were at their lows and averaging into these cheap prices and sticking to your long-term investment strategy would have been a much more rational decision and produced far better performance.

If you’d plucked up the courage to put a dollar into the Australian share market (S&P/ASX 200 Accumulation Index) at the end of February 2009 (pretty much the low point of the GFC), it would now be worth $2.10 (at 31 March 2016). But if you waited until the end of February 2013 (after markets had calmed down a bit) to put your dollar in, it would be worth $1.40. Loss aversion can be expensive, particularly if it sees you diverging from your long-term asset allocationThe way you spread your portfolio among different types of investments (asset classes). For example, if you had $10,000 to invest you might decide on an asset allocation consisting of 50% term deposits and 50% shares..

What does loss aversion mean for your portfolio?

Aversion to loss can spell trouble for investors and there are a few things to look out for when it comes to this psychological bias.

  1. VolatilityVolatility measures the rate of change of an asset’s price and is a term usually associated with shares. The higher the rate of volatility, the more a share price ‘bounces around’ in the short term. and risk

VolatilityVolatility measures the rate of change of an asset’s price and is a term usually associated with shares. The higher the rate of volatility, the more a share price ‘bounces around’ in the short term. (how much the price of an investment bounces around) is often regarded as a measure of risk. But if you ignore price fluctuations (and aren’t held hostage to them through margin lendingMargin lending is a special type of lending, usually used to fund share purchases. A margin loan requires you to maintain a certain level of loan to valuation ratio (LVR) or be faced with a margin call (where the lender gives you notice to repay some of the loan). If margin calls are not met, the lender is typically allowed to sell your shares to repay the loan. Margin loans are a lot riskier for the borrower than most other types of borrowing used in our day to day lives., for example) volatilityVolatility measures the rate of change of an asset’s price and is a term usually associated with shares. The higher the rate of volatility, the more a share price ‘bounces around’ in the short term. becomes less of a risk. That is, if you are prepared to hold on through choppy markets and not sell down (simply because you feel uncomfortable, not because the investment thesis has genuinely changed), price movements are irrelevant. All that matters is the price at which you buy, the price at which you sell and income received in the interim.

However, if loss aversion gets the better of you and a downward price movement causes a panic-stricken sell-down of a portfolio, irreparable harm will have been done to your long-term returns. Not only have unnecessary transaction costs been incurred, you’ve reduced your exposure to a particular asset or asset class at precisely the time that it might have been rational to increase it.

VolatilityVolatility measures the rate of change of an asset’s price and is a term usually associated with shares. The higher the rate of volatility, the more a share price ‘bounces around’ in the short term. isn’t risk, but loss aversion can make it a risk, if you are tempted to sell out during choppy markets. If you are concerned that your loss aversion might lead to poor investing decisions, consider opting for a more conservative portfolio, or lower volatilityVolatility measures the rate of change of an asset’s price and is a term usually associated with shares. The higher the rate of volatility, the more a share price ‘bounces around’ in the short term. investments.

  1. Entry point matters

If you’re a long-term holder of investments, a market sell-off can be a great buying opportunity. After all, the price at which you buy an investment is a key factor in determining the eventual profit or loss.

In the Boxing Day sales, everyone is out buying the bargains, but in the depths of the global financial crisis many investors didn’t have the stomach to continue to invest their portfolios, and sat on the sidelines worried that markets would go down forever. This worry was driven by loss aversion and it meant many investors missed out on a rare opportunity to buy into high quality companies at very attractive prices.

  1. Inability to sell losers

Loss aversion also manifests itself in our inability to part with unsuccessful investments. Distinct from a market sell-off where investments uniformly plummet, sometimes you find yourself with an investment that has gone down and is now unlikely to generate the returns you anticipated due to some change in the  fundamental investment thesis (for example, company management or government regulations might have changed).

Instead of selling the investment because your thesis is blown and you’re therefore unlikely to generate the returns you require, you hold onto it. Why? Because loss aversion sees us making investment decisions on the basis of whether a profit or loss has been made to date.

If a loss has been made investors are much more inclined to hold onto their loser simply out of the hope that it will recover its losses. But as the saying goes, ‘hope isn’t much of an investment strategy’ and basing investment decisions on what’s happened to an investment in the past isn’t much of a strategy either.

While we are certainly not predicting an imminent downturn, you should steady yourself for the possibility that in coming years we will again experience a correction and it will be painful. After a period of relatively stable markets, it is easy to say, ‘I will invest rationally during the next correction’, but when the markets are down day after day, loss averse human nature can get the better of us. If you spent a large part of January and February this year nervously eyeing your portfolio and considering selling down (or actually sold), it may be worth using these calmer times to revisit whether your asset allocationThe way you spread your portfolio among different types of investments (asset classes). For example, if you had $10,000 to invest you might decide on an asset allocation consisting of 50% term deposits and 50% shares. is too aggressive.

Loss aversion is a natural human tendency, but when it manifests itself in selling down just because markets are volatileVolatility measures the rate of change of an asset’s price and is a term usually associated with shares. The higher the rate of volatility, the more a share price ‘bounces around’ in the short term. A share or asset with a high rate of volatility is said to be 'volatile'., it undermines your long-term investment strategy. Staying the course and keeping your emotions in check are invaluable in achieving your long-term goals.

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[1] Example adapted from “Thinking, fast and slow” by Daniel Kahneman