In recent weeks there have been plenty of negative headlines about global stock markets. The coronavirus pandemic has had a huge impact on the economy; indeed, in mid-March, the FTSE 100 experienced its biggest one-day fall since 1987.
If you’ve been following the stock markets closely you may be experiencing something that psychologists call ‘loss aversion’. But what is loss aversion? How does it manifest itself? And what does it mean for your investments?
Loss aversion explained
The theory of loss aversion suggests that, for individuals, the pain of losing is psychologically twice as powerful as the pleasure of gaining.
Behavioural science experts Amos Tversky and Daniel Kahneman performed an experiment to demonstrate a clear example of human bias towards losses. The experiment involved asking people if they would accept a bet based on the flip of a coin.
If the coin came up tails, the person would lose $100. If it came up heads, they would win $200. The results of the experiment showed that, on average, people needed to gain about twice as much as they were willing to lose in order to accept the bet. In other words, the potential gain must have been at least twice as much as the potential loss.
As a result of this bias, when people are faced with the prospect of making a choice, such as an investment decision, they typically have a stronger preference for avoiding possible losses than for making gains. Individuals are willing to give up more potential profit in order to protect themselves against loss.
Loss aversion can manifest itself in several ways when it comes to your investments:
- Choosing to invest in ‘safe’ products that offer little or no return (or often lose money in real terms when the effects of inflation are considered)
- Selling shares because they are worth more than you paid simply to take a profit, rather than being patient and holding them for a longer period that might see further gains
- Not selling investments that are below the price you paid because you don’t want to take a loss
- Cashing in ‘winning’ investments instead of ‘losing’ investments because you don’t want to accept ‘defeat’
- Selling to avoid further losses when the reason for your investment says you should buy more
Why recent volatility has magnified loss aversion
When markets are volatile, it’s quite possible that you take more notice of the value of financial indices. This may just be subconsciously through news headlines or social media updates.
Greater media coverage of the financial markets has increased investor awareness of market volatility and the potential for losses. And, because the news coverage often focuses on falling share prices, you may have evaluated your portfolio more frequently than you otherwise would.
The consequence of this environment of heightened and more frequent awareness of market volatility is that you’re more likely to make irrational investment decisions.
Deviating from your long-term strategy as a result of these psychological biases can cause you to fall short of reaching your risk and return objectives. While loss aversion may be deep within our psyche, an awareness of this bias can help you to examine your own decision-making and avoid excessive short-term portfolio evaluation that can heighten the impact of loss aversion on your portfolio.
The risk of spending time out of the markets
During periods of volatility, you may be tempted to retreat to safer assets and to exit the markets. The chart below shows that spending time out of the markets can have a significant effect on your long-term returns.
Here, if you had missed just the five best investment days between the start of 1980 and the end of 2018 you would have sacrificed $232,550 in returns. That is around £187,000 in lost growth for missing just five days.
If you’d been out of the market for the best 30 days, you would have missed growth of $534,497 (around £430,000).
Your financial planner can help
A good financial planner isn’t just here to invest your money and to review your holdings once a year. They also act as a mentor and a sounding board during times of uncertainty.
Your planner will keep in mind your investment behaviour and can counsel you against making any knee-jerk decisions that may damage your long-term financial plan. They are here to look after your future interests ahead of your temporary emotional pain.
If you’d benefit from a review, or advice on your portfolio in light of current market conditions, please get in touch. Email firstname.lastname@example.org or call us on 01454 416653.