What is loss aversion and how to avoid it?
Loss aversion refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains: loss aversion implies that someone who loses $100 will be more disappointed than another person will be happy from receiving a $100 windfall1. Some studies have even suggested that losses are twice as powerful, psychologically, as gains. This principle of loss aversion is very prominent in investing and in constructing portfolios designed to achieve investor’s long-term objectives.
As investors, we know that over very long periods stocks have outperformed bonds – by a lot. According to data from Ibbotson SBBI, a dollar invested in U.S. large-cap stocks in 1926 would have grown to $7,353 by the end of 2017. If you invested that same dollar in Treasury bills, it would have become $21. Even when knowing this, we still experience loss aversion when we see the values of our property and investments decrease.
Loss aversion can lead investors to check investment portfolios more frequently. Investors who checked on their portfolios weekly or even daily tend to make decisions as though they had a similar time horizon even though their actual time horizon may be in the decades. Investors’ perception of risk begins to increase as they check on their portfolios more frequently. In reality, investors would be better served to think about their investments in terms of their holding periods. The odds of losing money in risk assets with positive expected returns, like stocks, declines with time. Thus, the longer an investor intends to hold the asset, the more attractive the risk asset will appear, as long as the investment is not evaluated frequently. As seen in the chart below, the longer the holding period, the less risk there is in holding risk assets.
Investors with even as short of a time frame as five years have not experienced a cumulative loss in a blended portfolio of 50% stocks and 50% bonds in any rolling 5-year period in the past 79 years.
The further we remove ourselves from the inexplicable day-to-day gyrations of the market, the less risky we will perceive our investments to be. As a result, the less often we look at our portfolios, the less likely we will be upset and tempted to tinker. Tinkering rarely, if ever, helps us meet our long-term goals. It more likely results in increased costs, both explicit and implicit. The explicit costs include trading costs and taxes. The largest implicit cost of tinkering is opportunity costs. Missing out on tremendous market returns because you have been parked in cash for the past 10 years, still shell-shocked from the last bear market, is an opportunity cost.
Over the long-term, the market should do most of the heavy lifting for us, assuming we just stay along for the ride.
1Loss aversion was first identified by Amos Tversky and Daniel Kahneman.
Brad Lyons, CFP®