Successful Investors Aren’t Afraid To Lose
More than 100 million Americans watched the Super Bowl on Sunday, and on Monday morning they all were talking about the same play. The most vocal, of course, were the fans in Seattle, whose team suffered a crushing loss after a late turnover on the goal line. The way this game was won – and lost – will be a topic of conversation for many years to come. But the emotional reaction of the fans is not just sports fanaticism at work; it’s an example of basic human behavior that guides how we react to winning and losing.
This week, Seahawks fans are suffering the effects of loss aversion, a behavioral trait that has been the subject of extensive study, including in the world of finance. Loss aversion refers to people’s tendency to strongly prefer avoiding a loss over experiencing a gain. In other words, we hate to lose more – perhaps much more – than we love to win. The concept of loss aversion was first demonstrated by psychologists Amos Tversky and Daniel Kahneman, and is featured prominently in Kahneman’s excellent book, Thinking, Fast and Slow.
Every investor knows investments can lose value, but few know the important role that loss aversion can play in their decision making. Some might strive to avoid losses altogether, or at least keep them to a minimum, by trying to pick the winners and avoid the losers. This is an extremely difficult task even for the most highly trained fund manager, and is virtually impossible for the individual investor. A likely outcome of this approach, in fact, is buying when prices are high and selling when they are low.
For others, loss aversion opens the door to a close relative known as risk aversion. By investing in low-risk, low-return assets, investors willingly accept smaller gains in order to avoid more painful losses. Conservative investments reduce market risk in the short term, but introduce more challenges in the long term, as portfolio returns struggle to fund longer retirement periods and offset the effects of inflation.
Loss aversion is most damaging in periods of sudden or significant market decline. Ironically, in an effort to avoid the pain of loss, investors will sell into a down market, generating real losses that previously existed only on paper. And in most cases, the same loss aversion will prevent these investors from getting back into the market when stocks are at their cheapest, making it that much harder for the portfolio to recover.
Investment advisors play many roles for their clients, but helping them understand the pitfalls of investor behavior is one of the most important. There is nothing wrong with hating to lose, but in some areas of life, like sports and investing, losses are unavoidable. Successful investors take a rational approach to loss aversion by developing a long-term investing strategy, understanding their own tolerance for risk, and building stable, well diversified portfolios. They recognize the quality and resiliency exhibited by the U.S. stock market, and patiently invest in a way that captures those benefits over time.
It appears that NFL fans recognize quality and long-term success as well. The Seattle Seahawks won the Super Bowl in 2014 and came within a yard of another victory this year. Las Vegas oddsmakers have already opened the betting to guess next year’s Super Bowl champion, and the Seahawks are the odds-on favorite.