1. Imagine that you are richer by €20,000 than you are today and that you face a choice of two options:
1. Receive €5,000; or
2. A 50% chance to win €10,000 and a 50% chance to win nothing
2. Imagine that you are richer by €30,000 than you are today and that you face a choice of two options:
1. Lose €5,000; or
2. A 50% chance to lose €10,000 and a 50% chance to lose nothing
Which options did you chose?
In both situations, you end up in the same. People tend to take the sure thing when it is a gain but don’t want a certain loss so much that they are willing to gamble an even bigger loss in an attempt to losing nothing.
These questions were written by Dr Daniel Kahneman who was awarded a Nobel prize for his work in the area of behavioural finance. He and his colleague Amos Tversky found that the pain of loss is about twice as great as the pleasure as the equivalent gain.
Although I haven’t spent decades of my life researching behavioural finance, I have worked as a financial advisor for over 20 years and I see how people react in different market conditions. While I think investors are becoming more knowledgeable about their investments, there is still this fear of loss.
It is seen most acutely in the initial years of investment when the money hasn’t had any time to grow and compounding hasn’t had a chance to do its thing. Despite decades of evidence showing that the longer you stay invested the lower the chances of a negative return, it can be difficult for investors to see that long ahead. It is in the initial years that I get the most client phone calls. No one likes seeing their money fall in value, even if it will grow in the long term. This year has been particularly bad for people who invested last year. 2021 was a great year in the markets, with double digit returns. Those returns were gone when Russia invaded Ukraine at the end of February. Some clients went from euphoria to fear. It is at this stage that you discover your real risk profile.
Another way people’s fears play out is they use the wrong metrics to measure the success of their investment. People constantly judge it against the highest point of their investment and not against how much they actually put in. I have lost count of the amount of clients who have made good returns but are disappointed because they sold at a time when their money was coming down from a high. And funnily, I don’t get similar complaints of people who sold out and markets continued growing. Those people tend to be more content. They needed the money and so they sold their investment to fund their expense.
We need to move away from measuring investments against their high point, which can be an arbitrary point in time when you just happened to log in to check the value.
When investing, there is always going to be bad times when the value of your investment is down and you are at a loss. But if you are invested in quality assets and give it enough time, you will make money. And while the pain of a loss may well remain greater than the joy of the gain, it will be nothing compared to the enjoyment you will get from putting that money to good use. And that is what investing is for.
13 June 2022