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Investment Losses Loom Larger Than Gains – Blog 154

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Investment Losses Loom Larger Than Gains – Blog 154

7th September 2020

Paddy Delaney

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“Losses loom larger than gains”. Not my words but those of Nobel-Prize winning psychologists Daniel Kahneman and Amos Tversky (RIP). It was these two guys that first studied, tested and published research on this, in 1979.

Over recent years ‘behavioural economics’ (our decision-making around money) has become big business. But these two are said to be the founding fathers so to speak. If you have not read it (and have the stomach for a challenging read) I suggest you have a cut at ‘Thinking Fast & Slow‘ by Kahneman.

What’s Love Got To Do With It, Baby

They suggested that we hate losing something about twice as much as we enjoy gaining something! Think about it – in all walks of life it holds water. Take ‘love’ for example. I remember vividly when I was unceremoniously dumped by my first girlfriend! I was about 15 at the time – and ‘devastated’ was not the word for how I felt! Despite my father telling me; ‘Cheer up son, the next one is always better’ (!!!!) I was inconsolable for a week or two.

When I had recovered, and probably after several years of searching, ‘the next one’ to use my father’s words – came along. As great and exciting as that probably was, I don’t recall the joy of gaining that relationship even being remotely comparable to the loss of the previous relationship – even though she was a truly lovely person of course!

Losing feels really bad. ‘Badder’ than winning feels good. Andre Agassi noted in his autobiography “A win doesn’t feel as good as a loss feels bad, and the good feeling doesn’t last as long as the bad. Not even close.”.

Our brains are wired, have always been, to avoid loss. We focus on avoiding a threat much more readily than we pursue gain. It is what has helped human to survive and prosper on the planet. When we lived in caves I guess we spent about twice as much time and energy avoiding the human-eating beasts than we did on searching for our dinner! We are all still wired that way – it is our defense mechanism and means of survival.

Of course we can all have occasions where we short-circuit our wiring but humans are loss averse in what they do. We don’t want to lose what is important to us.

I remember clearly some of the first conversations I had with potential investors when I first started working as an advisor many years ago. Based in a bank, a customer might come in complaining about the rate of interest on deposit. If they asked about getting better returns, some of my initial conversation went along the lines of;

Paddy: What type of return are you hoping to achieve over the long term Mr. Customer?

Mr. Customer: As much as I can get

Paddy: How much volatility (or risk as I used to naively call it back then) are you willing to take?

Customer: Are you mad, I’m not taking any risk with any of this money – I worked too hard for it

I was perplexed but also somewhat amused, and only after a while did I cop it; we want the gains – but not if we perceive there to be a high probability of loss. Of course, back then, it was purely due to my own inability to communicate effectively that volatility is not the same as loss. Therefore many of those conversations didn’t make it past the post. To those almost-investors I apologise unreservedly!

Loss Aversion In Investing

Last week we shared some interesting stats about Active Fund Managers not beating the market returns. To be clear, an investor can achieve the market returns by investing in an index, or combination of indices, and sitting tight. Not reacting to fear when there are lows, or reacting to greed when there are highs. That is simple but surprisingly difficult for the vast majority of investors – fact. Human nature works against us in trying to do so.

If a pension you own, which might represent 20 or 30 years of hard savings is falling in value, it’s not fun. Imagine it falling by 10, then 20, then 30 and then 40%.

Our brains are working over-time to tell us to run. The human reponse is to avoid any further loss – to cut our losses, sell the funds and stick it in cash. Human nature. Loss aversion. Fear.

But we KNOW that this is the absolute wrong thing to do. If we understand investing and how markets work (that they reflect human nature!), we know that this cut and run reaction has never been the right thing to do. We KNOW that the optimal response is to do nothing. But quite often, to remain invested feels wrong.

Successful Investor During The Recent Declines?

If you remained invested during the recent market decline and subsequent recovery I salute you. Your future retirement income or asset values are the better for it.

It was a violent and media hyseria inducing episode of temporary market decline. In fact, the market went down further and faster than it had since the Great Depression of the 1930s! It was savage.

The trouble with that episode however was that it was nearly too short for us to really be struck with ‘the fear’, and for our resolve to be truly tested! If the markets had fallen by another 10%, or indeed if the markets had not rebounded as yet, were still down 40% of our values – would we be still holding our nerve?

For context, in August 2010, a full 3 years after the markets suddenly started declining in 2007, they were still down about 30%. It was the following year that they rebounded and kept going for another 10yeara or so.

Simple but not easy to hold your ground – stick to the plan – keep ignoring the media and the nay-sayers when you are 3 years into a decline. But that’s what it takes to achieve long term investment success.

VIX Index

This week, by sharing with you one of leading measures of investor fear, we might understand why humans, not just Fund Managers, are not naturally very good investors!

The VIX Index has tracked data since early 1990’s. It has grown to be recognised internationally as the ‘Fear Gauge’ – the level of concern investors have about current market outlook and the future. It is a forward-looking index and is calculated in real-time. Of course, they have a complex method of calculating it – if that’s your bag you can read the white paper about that here!

What Does VIX Tell Us?

Looking at the above graph, which maps the level of fear among investors from 1990 to today. There are several fear peaks, if we may call them such.

In October 2008 fear was at it’s highest on record. The second highest peak was the end of March 2020 – peak Covid-19 fall-out. It will come as no surprise that these peaks coincided with the largest temporary market declines that we have experienced over the past 30 years.

The VIX index was at 14 in mid February 2020. When the pandemic became a reality the VIX index jumped to 65 on the 25th March. Investor fear was at a height that it had not been at since 2008, and understandably so.

What is less understandable is that swathes of investors sold out of equities and moved into commodities (Gold and others), Cash (which now often costs you money to own!) and Bonds at that time, after prices had started falling. Investors were reacting to the fear – I guess were trying to avoid further loss.

However, their investments were, at that very time, already in a temporary decline. The chart below shows the period 19th Feb to 31st March – a Global Equity was negative 30%+, and investors were still selling out. Not only were they not avoiding loss, they were consolidating loss.

We have seen this countless times before – many investors and fund managers do not stay invested when they should. Sometimes they knowingly do it – other times unknowingly.

The surival instincts kick-in and take over their reponse to the event. Doing what one believes will help them avoid the loss actually only consolidates the loss. Maybe it makes them feel better – but financially it’s ruinous.

Market Timing Anyone?

In my view, Market Timing, whether done by a fund manager or an individual investor, is usually done in order to make an investor feel better about what they are doing. It is done to make it easier as opposed to it being an informed decision on what will deliver the best investment outcome.

And you know what, if that is the basis of the decision, then that’s an investor’s prerogative. Provided you know that you are likely cutting off your nose to spite your face then fine – if that’s your call then that’s your call.

If you are already invested please make sure that you are prepared to withstand savage temporary declines that can potentially last for several or more years. If you feel that you cannot withstand such an event, that your supposed loss aversion will over-power you I believe there are two viable options: either hire an advisor that will keep you on track, or consider getting out and staying out before that potentially ruinous day comes.

Perhaps you are not invested, and are intent on waiting for the next big market bargain when markets fall again by 30%. Statistically there’s one every 5 years or so – so you could be waiting! Indeed waiting has proven to be far more costly than investing and suffering a temporary decline.

But if that is you, and yo u insist on waiting, maybe just maybe the VIX, as opposed to your gut or the wall of financial data and media predictions, is the thing to be watching!

Thanks for reading,

Paddy Delaney QFA RPA APA

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Paddy Delaney RPA QFA APA
Investment & Retirement Income Planner