The fear of losing money has been on investors’ minds lately — as well as in their guts. This common human trait is captured in the movie “Wall Street,” when Gordon Gekko says, “Nothing ruins my day like losses.”
Behavioral economists have a name for this normal psychological phenomenon: loss aversion. If finding a dollar on the sidewalk gives you a momentary thrill, but losing 50 cents through a hole in your pocket bugs you all day, you’ve experienced it firsthand.
When investors come under the influence of this trait, behavioral scientists and financial experts say it can lead to poor investment choices.
“People naturally have this fear of losing money, and it affects what would otherwise be rational judgment,” says Robert Koppel, author of “Investing and the Irrational Mind.”
Losses weigh more heavily
Koppel defines loss aversion as the natural preference for avoiding a loss over acquiring a gain. Behavioral economist Daniel Kahneman won the Nobel Prize in economics for his research with Amos Tversky that showed the psychological impact of a loss is two and a half times as powerful as that for a gain.
Koppel recounted one test the researchers did in which they asked people on the street to bet on the flip of a coin for a chance to win $10. Everyone was willing to bet $1, but people thought twice as the stakes rose, and they were rarely willing to wager as much as $6 — despite having a 50-50 chance of winning each time.
One subject who adamantly refused turned out to be a professional stunt man. “This guy routinely threw himself in front of moving cars, jumped out of second-floor windows and off of moving trains. But to bet $6 on a coin flip to make $10 was outside his risk parameters,” Koppel says.
Running from the bear
Joel Larsen, principal of Navion Financial Advisors in Davis, Calif., says loss aversion definitely reared its head during some of the most recent bear markets.
“This is why a lot of people bailed out at the bottom of this last meltdown in ’09 … and never got back in,” Larsen says.
Statistics from Morningstar show just how volatile the market has been — and how panic could have caused some investors to lock in their losses. For example, a $10,000 investment made on Oct. 1, 2007 in a Standard & Poor’s 500 index fund would have plummeted to just $6,492 by the end of October 2008, a traumatic time for investors following the bailout of Bear Stearns and the collapse of Lehman Brothers, among other calamitous events.
The stock market continued its downward slide through February 2009, at which point the investment’s value dropped to $4,983. An investor in a panic who sold at that point would have taken a loss of more than 50 percent. But in March 2009, the S&P 500 began to show signs of life. Had that investor stayed the course, the value of his or her money would have reached $9,396 by the end of June 2011 — still not a full recovery, but close to breaking even.
The tactical solution
When you consider that from the peak on Oct. 9, 2007, to the trough on March 9, 2009, the annualized return for the S&P 500 was a heart-stopping minus 43 percent — it’s no wonder many investors were emotionally distraught. But financial advisers say that emotional reaction is exactly what caused a lot of investors to dump all of their stock positions, even though doing so worked against their best interests in the long run.
Larsen stresses that he’s no advocate of the simple “buy and hold” posture.
“We’re tactical asset allocators,” he says. “Buy and hold works in a secular bull market, like the one we had from ’82 to 2000, which was when a lot of (today’s investors) came of age. … We’re not in secular bull market now. We’re either in a sideways market or a secular bear market.”
David Hefty, CEO of Hefty Wealth Partners in Auburn, Ind., says his firm applied tactical analysis to cope with the stock market during the 2008 financial crisis. “During that time we were putting hedges on our equity exposure and increasing cash,” he says.
A rational approach
The fear of losing money isn’t always a bad thing, especially if, like most of Certified Financial Planner Michael Reese’s clients, you are fast approaching retirement or already retired. In those situations, the tendency to avoid the risk of losing your assets makes sense, because you have less time to recover from any losses you incur. But otherwise, Reese says, buying stock in a down market is like “investing on sale.”
“When you see a market crash, as a younger person investing, that’s an outstanding opportunity,” says Reese, founder and principal of Centennial Wealth Advisory in Traverse City, Mich. “It feels bad to see your portfolio falling in value, but you should also remember: ‘I’m buying all these shares so inexpensively that down the road these shares are going to represent some of the best investment returns I’ll ever have.'”
In Koppel’s view, the best antidote to loss aversion is to study the markets and develop a strategic investment plan, actions that he says “support rationality.” Patience is essential, too.
“But patience comes from being able to understand the process and your motives, to have a plan and then put that plan into action,” Koppel says.