Blog #28 Loss Aversion

I don’t know if Daniel Kahneman (Princeton economist, Nobel laureate 2002) has ever been to Singapore. If he did, he would probably find a lot of similarity between Singaporeans’ kiasu attitude (afraid of losing) and the concept of loss-aversion that he pioneered and made famous.

You are loss-averse if you hate losses so much that you either avoid it or deflect the pain of a loss irrationally. This implies that there are two main groups of loss-averse investors which I will call avoiders and deflectors.

An avoider is someone who avoids riskier assets like stocks, preferring the safety of cash or government bonds  A deflector does invest in riskier assets but tends to: (a) sell a winning stock too early and (b) hangs on to a losing stock for too long. The deflector is  loss-averse because by selling soon after a win, he wants to avoid the regret of not selling if the stock price drops below his purchase price. And by hanging on to a losing stock, he consoles himself that it’s just a “paper loss”, and there’s always a chance that the stock might turn around.

Kahneman and his collaborator, Amos Tversky developed Prospect Theory to explain why most people behave like loss-averters. The following S-shaped graph captures the essence of Prospect Theory.

Value Function

Kahneman and Tversky call this S-shape curve “value function”. I prefer to call it the win-loss curve. The win zone is in the top right-hand quarter and the loss zone in bottom left-hand quarter. The vertical axis measures the “value” of gains and losses. The horizontal axis measures the extent of gain and loss, relative to a reference point. The reference point is where the vertical and horizon axis cross.

The reference point plays a key role in Prospect Theory. When deciding whether to sell a stock or hang on to it, people tend to check the current stock price against their purchase price. The purchase price is a natural reference point for such decisions.

How to read the graph? Suppose you bought a stock for $5. If the stock is now $6, you will feel very happy.  If it goes up to $7, you feel happier, but the extra happiness now is not as great as when the stock went from $5 to $6.  This is the S-shape effect kicking in. In the jargon of Prospect Theory, you are experiencing diminishing sensitivity to gains. Diminishing sensitivity to gains and the fact that your $6 stock may fall in price if you wait will prompt you to sell now to avoid regret. This leads to short-termism.

What if the stock you bought is below your purchase price? You are now in the loss-zone.  Notice from the graph that two things as you pass from the win-zone to the loss-zone: (A) initially, the value function drops over a cliff (the steepest portion), and (B) as losses deepen, the value function declines more slowly.

(A) captures the main idea of loss-aversion, namely that a dollar lost is emotionally more painful than a dollar gained. People who are loss-averse avoid riskier assets for this reason. There are many such people in the world. For example, a  2015 Black Rock survey (below) finds that cash forms nearly 50% of the portfolios of Singapore investors. More shockingly, this strong preference for cash is also found among young investors who should have greater risk tolerance due to their much longer investment time horizons.

Holding cash.jpg

How can you learn to be less loss-averse and thus benefit from the higher returns of stocks?  I have four suggestions:

(1) Understand the basics of risk and return 

Stocks reward investors with higher average returns than corporate bonds, and corporate bonds in turn have higher average returns than government bonds and cash. This pecking order of risk and returns is as close to a scientific law as we can get in the often messy world of finance and you should take advantage of it.

(2) Don’t check stocks prices as often as you check your cell phone

Richard Thaler once performed an experiment to see whether people’s attitude towards risk is affected by the way returns are displayed. He told each subject that they can choose one of two investment funds: a riskier fund (A) and a safer fund (B). Fund A is invested in a stock index comprising large U.S. firms while Fund B is invested in a portfolio of U.S. Treasury bonds. Subjects were not given this information to avoid any preconceptions. They were merely shown charts that display the historical returns of the two funds as follows:

Short vs long term.jpg

The subjects in Thaler’s experiment were randomly assigned into two groups. One group were shown charts in the top panel which display the distribution of annual returns. The other group were shown charts in the bottom panel which display the distribution of simulated average annual return over a 30-year period. Thaler then asked each group what percentage of a hypothetical portfolio they would put in Fund A and Fund B.

Here are the results: subjects in the first group (who saw only annual returns) overwhelmingly preferred the safer option; they chose to put only 40% of their hypothetical portfolios in stocks. Subjects in the second group were much less loss-averse. They chose to invest 90% of their money in stocks.  In short, how returns are displayed did affect how people invest in a big way!

What are the practical lessons from this study? One implication is that people who check stock prices frequently are less likely to invest in riskier assets. This is because the more often you check stock prices, the more often you will see losses. Since losses are more painful than gains, you will freak out more easily, and before long, you will give up on stocks. To avoid the temptation of checking stock prices frequently, remove the stock trading app from your cell phone and do something more harmless when you are on the train (like watching Korean dramas).

(3) Invest long term

In point (1), I mentioned that on average, stocks have higher returns than bonds and cash. The phrase “on average” is not there to sound scientific; it is scientific!

Evidence using data that goes back many decades show that in almost every stock market, stocks outperformed cash and bonds in the long run. The difference between the average return for stocks and the average return for bonds is called the equity premium. For many markets, the effects of compounding the equity premium over time is nothing short of stunning (see chart below for the U.S. stock and bond market).

US Equity Premium.jpg

(4) Invest in yourself

Having a job that pays well is a blessing in so many ways. That includes your personal investment. Think of your income as a safety net that gives you the means to power your investments, cushion losses, and counter loss-aversion. Which is why you should take a holistic view and invest in yourself even as you invest financially.

Conclusion

Investors pay a heavy price of missed opportunities by being loss-averse. At the same time, we are not doomed. The key to growing wealth successfully lies in taking the right type of risk (by holding diversified asset classes), taking time, and investing in yourself by staying relevant and economically productive.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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