Investor danger: psychology of loss is worse than the pain

by Philippa Huckle, Sunday Morning Post, January 23rd, 2005

We all suffer from loss aversion - the psychology of giving more weight to losses than to gains. And we are hard-wired against danger in the form of a genetic phenomenon, otherwise known as the fight or flight response. For investors, this survival instinct has important consequences.

The investment universe operates entirely in the realm of uncertainty. To be a successful investor you have to get a handle on risk. Webster's dictionary defines risk as "the possibility of loss or injury; peril". We've survived as a species because our ancestors were psychologically programmed to avoid risk. As a result, our emotional safety mechanism is wired to instinctively shy away from a potential loss.

In simple terms, this means we find it hard to remain invested for the long term. Given the chance, as investors we'd rather bolt for the exits in down markets.

Studies in Behavioral Finance reveal that we feel the pain of loss twice as much as the pleasure of a corresponding gain. For example, $10,000 will upset you about twice as much as gaining $10,000 will make you happy - but this isn't the end of the story. Loss aversion has some unexpected implications for investors.

Imagine you owned a sound investment which delivered good long-term returns of 15 per cent per annum with a low volatility of 10 per cent standard deviation. Using these figures we can calculate the probability of this investment delivering positive returns over various timeframes.

There's a 54 per cent chance it will be up on any given day; a 67 per cent probability of positive returns over any one month; and a 93 per cent chance of positive returns in any one year. We can see that the longer we're invested, the more likely we are to get positive returns. We can also see that it's perfectly normal for investment returns to be negative for a certain percentage of the
time.

In this case you can expect a positive return in about 67 months out of a 100, and a negative return in the other 33 months. These down periods are perfectly normal even while the investment is busy delivering its 15 percent annualised return over the course of time.

When we look at this on a daily timeframe, our calculations tell us to expect a positive result 54 days out of 100, or just over half the time. So we'll feel good half the time, when the investment is up. The problem is that, being loss averse human beings, we'll feel twice as bad the other half of the time, when the investment is down.

So as a result of this, if you're checking the price daily, you will quickly become emotionally overwhelmed. You will feel twice as much pain as pleasure, and your survival instinct will scream at you to avoid this situation at all costs. You will be very tempted to end the pain by selling - even though the investment is behaving exactly as expected, and the long term returns are on track. Overwhelmed by the psychological pain of short term loss, we find it hard to remain invested for the long term.

In 1883 Chancellor Bismarck set 65 as the retirement age for the world's first governmentsponsored retirement scheme. Back then, before the discovery of antibiotics, and when life expectancy was far shorter than today, only a few percent of the population lived past this age. So people received salaries that lasted for practically their whole lifetime. But thanks to advances in modern medicine and better living conditions, today's average life expectancy is 80 years - leaving us with about 20 plus years of retirement to finance. As a result, we are all forced to be long term investors.

Coping psychologically with investment risk is a bit like visiting the dentist: we do it because the consequences of not doing so are far more painful. We must face the pain and grudgingly accept risk, because if we don't, the consequences are far worse - like running out of money in our old age, being forced to downgrade our lifestyles, or being unable to finance our children's education.

A better understanding of our investor psychology will help us to manage our instinctive genetic response to risk. Each of us needs to set clear financial goals; diversify our capital into an asset allocation properly formulated across uncorrelated market cycles; and commit to a rebalancing strategy. We then need to overcome our inherited, knee-jerk reaction to temporary short-termloss.

Lessen the pain; check your statements less frequently, and give long term market probabilities the opportunity to work to your advantage.

Philippa Huckle is founder and CEO of The Philippa Huckle Group, an independent advisory firm.