Winning v losing

When markets go down, investors feel worse than the happiness they feel when markets go up by the same amount.

When the markets are rising, no one calls me! It’s a different story when the markets are falling. For example, investors become fixated on their most recent contribution. If that’s dropped, they panic and refuse to invest any more, forgetting about their remaining investments which have done alright over time.

In this article, we explore the psychology of loss aversion – an irrational cognitive bias that describes why the pain of losing feels twice as powerful as the pleasure of gaining.

“Losses can be twice as powerful, psychologically, as gains.”
Kahneman and Tversky (1992)

This graph shows the perceived value of gain and loss v strict numerical value of gain and loss: A loss of $0.05 is perceived with a much greater utility loss than the utility increase of a comparable gain.

Winning v losing

This tendency towards loss aversion can lead to bad decision-making and predictable mistakes, which makes us easy to dupe. For example, it’s the reason why many people are tempted to buy a pointless extended warranty.

Not only that, but restoring a loss makes us feel better than gaining the same thing.

For example, a home shopping company measured customer satisfaction. It turned out that ratings were higher after there had been a problem and it was fixed than they were if there had never been a problem in the first place. That’s not to say organisations should introduce problems just so they can fix them!

Habits like this don’t have conscious awareness. That means it’s hard for us to make a new decision. We are automatically triggered by familiar environments.

For example, people choose Pepsi in blind tests, because it tastes better. But Coca Cola outsells Pepsi because it’s promoted on feelings and emotional reactions rather than facts. The automatic association triggered by the Coke ads prompts people to prefer the brand.

The other influence that’s incredibly potent – over and above factual or logical proof – is social proof. What Cialdini calls “people like me” tell you what are your appropriate choices.

If everyone seems to be looking up at the sky, you’ll probably look up to see what they’re looking at. If everyone seems to be taking their money out of the market, you’ll be tempted to join them, even if that doesn’t make rational sense – and it doesn’t.

This video gives an example of the power of social conformity:

It’s so ridiculous you’d probably like to think: “I’d not fall for that. I’d like to be the one that’s different!”’

You can.

What this means to you

It is possible to overcome these instinctive biases by being aware of them and trusting the science.

Our friends at Dimensional say: “When headlines worry you, bank on investment principles”. These are:

Uncertainty is unavoidable

The past three years have seen global upheaval, but demonstrate the case for weathering short-term ups and downs and sticking with your plan.

For example, at the three years ending February 28, 2023, the Russell 3000 Index (a broad market-capitalisation-weighted index of public US companies) returned an annualised 11.79% – this slightly outpaced its average annualised returns of 11.65% since inception in January 1979.

Market timing is futile

The idea of using short-term strategies to avoid near-term pain without missing out on long-term gains is seductive, but research repeatedly demonstrates that timing strategies are not effective. Wait long enough, and the markets WILL rise.

See our article: Ticka-ticka-ticka-ticka-timing

Diversification is your friend

Diversification is still an incredibly effective tool. By spreading the risk, diversification can reduce the potential pain caused by the poor performance of a single company, industry, or country.

In short, choose low-cost funds, diversify widely, ignore the hype, and stick with the plan for the long-term. We hope this helps take the negative emotion out of investing.

Much of this month’s content was inspired by the ‘Hacking Your Mind’ TV series ‘Weapons of influence’ episode broadcast on 18/4/23.

Lance Baron

Certified Financial Planner (CFP) based in East Sussex, UK. We support people in Southeast England with more than £500K to invest by building a financial plan that will help them live the life they want… until age 100