The theory of ‘loss aversion’ suggests human beings instinctively feel the pain of loss more acutely than the enjoyment of gain – with potentially self-destructive implications for less disciplined investors
One of the many interesting aspects of behavioural finance is that, even if you do not know the name or the workings of a particular theory, you are very likely to be familiar with the feeling or instinct that underpins it. Take for example the idea that human beings feel the pain of financial loss twice as keenly as they feel the enjoyment of any gain – as an investor, does that ring true to you?
For the record, this is known as ‘loss aversion’ – or, more formally, ‘Prospect theory’ – and was developed by the founding fathers of behavioural economics, Daniel Kahneman and Amos Tversky. In one experiment that helped to flesh out their theories, the pair asked people if they would accept the result of a coin toss if they knew they might win $150 by calling it right but, if they called it wrong, they would lose $100.
It turned out many people would not take the bet and eventually Kahneman and Tversky concluded that, broadly speaking – in what after all is a 50/50 call – people are willing to put $100 at risk as long as there is the prospect of winning $200. From this came the idea that people feel losses twice as much as they feel gains and from that comes the following graph, which we should stress is for illustrative purposes only.
Psychological impact of checking performance at different frequencies
Past performance is not a guide to future performance and may not be repeated.
You may of course wish to debate the point people feel loss twice as keenly as gains but, taking that as our starting point, what we have done here is to create what you might call a ‘psychological graph’. It illustrates how people might have felt about the performance of the fund with the longest track record we run, here on The Value Perspective, depending on how often they checked how it was performing.
The top line in the graph is the fund’s actual performance and, at the risk of sounding immodest, investors have done pretty well over the last 10 years. Anyone who had been checking the fund’s performance on a daily basis, however – and really did feel loss twice as keenly as gain – is going to be feeling pretty bad about their investment and is unlikely to have been willing to hold it much past the great financial crisis.
Anyone who did so monthly would probably not have felt much better – or stuck with the fund much longer – and, while things naturally improve on a quarterly and annual basis, the psychological ride is not nearly as pleasant as the actual outcome. None of which is to say investors should only check their portfolios once a decade – only that they bear in mind equity investment needs to be approached with a long-term mind-set.
As we have said before, value investing can be a tough road to travel yet more than a century of stockmarket data suggests the ‘destination’ of strong long-term outperformance could make the effort worthwhile. Sadly, that instinctive loss aversion of human beings may go a long way to explaining why so many investors have instead plumped for the supposedly lower-volatility companies and funds that today look decidedly expensive.