Avoid this Common Portfolio Killer
Would you rather win a dollar -- or not lose a dollar you already have?
If you're in any way typical, the answer is the former. Losing money always seems more painful than winning money is pleasurable.
This statement doesn't merely apply to wealth builders. It's basic human nature. Psychologists have a name for the condition -- loss aversion. While it might sound relatively harmless -- or even positive -- loss aversion can cripple an investment strategy.
So let's talk about how to inoculate your portfolio from its effects.
The father of loss aversion
Daniel Kahneman became acquainted with loss very early in life. Born in Israel in 1934, Kahneman moved to Paris as a child, just before the start of World War II. It was a time of great risk and uncertainty. Kahneman was forced to wear a Star of David and obey a strict curfew. His father was arrested by the Nazis, before being released thanks to the intervention of his employer.
One day, when leaving a playground, the young Kahneman noticed a member of the SS following him. Terrified that he would be arrested, Kahneman tried to avoid eye contact.
It didn't work. The Nazi soldier grabbed him -- only to hug him fiercely, show him a photo of his own son, and give him money from his wallet.
Kahneman was floored by this unexpected display of humanity. It was a formative experience that sparked his interest the field of psychology.
Now 81, Kahneman is a Nobel Prize-winning legend who has made major contributions in both psychology and behavioral economics. One of his most famous insights led to the idea behind loss aversion.
Kahneman's research showed just how powerful the principle is. In an experiment with fellow psychologist Amos Tversky, the researchers discovered something surprising. People were asked to gamble on the outcome of a coin flip. They could win $20 if they called the flip correctly. Yet they would lose $20 if they failed to do so.
Most people involved refused the terms of the bet. Instead, they demanded $40 in winnings in exchange for exposure to a $20 loss.
That meant a loss, in psychological terms, has twice the impact as a similar gain. It's the same reason compulsive gamblers are compelled to dig huge holes trying to recoup losses. The impact of such losses is profound. So profound, in fact, that we can't always control our reaction.
How do I avoid loss aversion when investing?
What applies to gambling applies equally to the stock market. When a stock drops quickly, our natural inclination is to sell before it drops any further. This is classic loss aversion in action.
Selling based on very short-term performance is a common and potentially harmful investing error. Yet it's an error many of us can't avoid.
Think of it in these terms. Over the last few years, the stock market is way up. Yet that doesn't mitigate the psychological response we have to watching our share prices plummet on any given day.
The S&P 500 perpetually rises and falls. Since it was established more than 50 years ago, on any given day, it has fallen about 46-percent of the time. So even though the market has steadily risen, there have been a lot of down days to negotiate.
And that's where loss aversion does its nefarious work. If we feel losses twice as acutely as gains, then losing 46-percent of the time (and winning 54-percent of the time) is no longer a net positive. We become more likely to act irrationally -- and make portfolio crippling mistakes.
So how do we avoid the impact of loss aversion on our investments? Here are some simple, yet effective strategies:
- Do not live and die with daily market results. Force yourself to take the long view.
- Check your portfolio with less frequency. If you don't expose yourself to short-term losses, you lower the risk of overreaction.
- While the S&P 500 is down on 46-percent of days, that percentage drops to 40-percent when calculated monthly. If you check your portfolio monthly rather than daily, your odds of seeing losses (historically speaking) decrease by six-percent. Yearly is even better, as historical losses drop to just 27-percent.
- Ignore media hype. The financial media loves to push a dramatic narrative. Every slight dip is breathlessly reported as the prelude to a correction. Tune the noise out.
- If you're feeling the urge to make a decision based on emotion, go back and review the history of the stock market. You'll be immediately comforted. Over the long-term, stocks have been a fantastic growth driver. The market has never failed to grow over a ten year period, except during the rare event of a financial crisis. Even then, the losses were made up quickly.
- Recognize that loss aversion isn't just about not selling too soon. It's also about being willing to cut losses when confronted with a hopeless investment. Sometimes, we're tempted to ride an investment into the ground with the dim hope it will recover. Resist this urge. Recognize when an investment has gone bad, beyond typical market turbulence.
Loss aversion is a powerful cognitive bias. Yet by recognizing its effects, we can mitigate its influence -- and keep our portfolios headed in the right direction.