Published On: August 27, 2020
Written by: Ben Atwater and Matt Malick
Behavioral finance is the crossroads of psychology and economics. It recognizes that investors are not always rational, have limits to their self-control and have biases that influence their decision-making.
This is the last essay in our behavioral finance series. Readers have been particularly interested in this series. For your easy reference, we created a landing page for Behavioral Finance on our website. On this page, you will find all of our behavioral finance essays. Please feel free to share with your friends, family, and business associates.
Loss aversion is people’s general preference for avoiding losses over acquiring gains. Academic experiments indicate people are twice as sensitive to losses. The classic experiment in this area is to introduce the scenario below and have subjects choose their preference.
Most people choose number two. However, from a probability standpoint, the expected return of number one is $250 while the expected return of number two is only $125.
Nonetheless, we are inclined to worry more about loss than gain, so we tend to choose the “sure thing.” This has all kinds of investment implications.
Often in the search for safe investments, people end up making popular investments. There is a sense of safety in numbers.
When investors do stumble into losses, they tend to panic and think selling after a big drop will limit further declines. Therefore, investors often buy high (when an investment is popular) and sell low (when the price has fallen). But the psychology of loss, like most things in behavioral finance, is not clear, and sometimes even contradictory.
The endowment effect is a tendency for people to retain something they already own, rather than acquire the same thing when they do not already own it. There can be good reasons for this, like capital gains tax avoidance, diversification, investment philosophy, etc.
While some investors might panic sell, other investors may not sell because they can psychologically protect themselves from loss by not closing out their position. In other words, to avoid experiencing the pain of a loss, an investor might continue to hold an investment even as their loss magnifies. By holding on, they can tell themselves they have not “locked-in” the loss and the investment will rally back.
One positive effect of this could be an investor holding a position through a cycle and ending up ahead. The opposite, and negative effect of this, is the investor continuing to hold a losing investment longer than they should and suffering bigger losses than necessary.
We have always felt it easier to buy an investment than to sell one. We do not think we are alone in this. Whether it be the tax barrier of capital gains when a stock is up or the psychological loss aversion when a position is down, selling is more difficult than buying.
Our investment philosophy favors being long-term investors. This means standing behind our investment thesis. When ideas work, we like to let our winners run. When ideas do not work, we favor holding while continuously reevaluating our thesis.
Our sell discipline is separate from how a stock performs and we highly orient it toward cash flow analysis. We have found that persistently weak cash flow is an important sell signal. We think professional investors by-and-large have better sell disciplines than individual investors, however, even many pros fail in this area. Selling arguably is the hardest part of investing.
An excellent example of loss aversion more related to personal finance (and indirectly related to investing) is the idea of a “Save More Tomorrow” 401(k) plan. In such a case, an employee enrolls in the plan and the plan automatically increases contributions when the employee receives a pay raise using some percentage of the raise. Therefore, the employee never sees less take-home pay while at the same time embarking on a disciplined plan for regularly increasing retirement savings. In these kinds of plans (which are rare but do exist) employee contributions are 200% higher than average.
The savings mantra of “pay yourself first” is really a form of loss aversion. If you are spending all your income and decide to save more, you will lose some of your ability to consume. But, if you never consumed all your income in the first place, it is much easier to save.
Remember that with loss aversion, investors will take greater risks to avoid losses than they would to seek out gains. This is evident from both a saving and an investment perspective. It is hard to increase your savings by lowering your consumption. Just as it is hard to stay the course when the market is plummeting.