Loss aversion makes the pain of losing money far greater than the joy of making gains. This can stop us from accumulating mutual funds or stocks when markets fall
In early-March 2020, amidst the discussions about the spread of COVID-19, I conducted a small survey of my own about how the markets will perform. The general opinion was that markets can fall further in the near term due to fears, but may recover soon (within six months) and resume the rally. There was no fear of a multi-year impact of the virus outbreak on the economy or the markets. After the survey, I wrote on a board in my office: “Logically, shouldn’t a long-term investor be buying, as this fall is just temporary?”
There are numerous studies that show how natural disasters have provided good entry points for investors to add to their equity investments. So, what stops them? Let’s explore one important concept in the psychology of decision-making: loss aversion.
The prospect theory
Paul Samuelson, a Nobel Prize winning economist, once asked a colleague whether he would accept the following bet: A 50 per cent chance to win $200 and a 50 per cent chance to lose $100. The colleague turned it down. He said the pain of losing $100 would be more than the joy of winning $200. He was willing to take a series of such bets rather taking just one. Was he irrational? No, he was normal.
Daniel Kahneman and Amos Tversky have discussed in their paper, “Judgement under uncertainty” that an individual feels more pain for a loss of $100 than the happiness for a gain of $100. The figure below is a graphical representation of the value function as described by Kahneman and Tversky, known as the Prospect Theory (notice the steeper loss curve versus the gains curve). Existing evidence suggests that the ratio of the slopes of losses to gains of the same amount is about 2:1.
Richard Thaler explains in his research paper that “the role of mental accounting is illustrated by noting that if Samuelson’s colleague has this utility function, he would turn down one bet but accept two or more bets as long as he did not have to watch the bet being played out.” He goes on to conclude that when decision-makers are loss-averse, they will be more willing to take risks if they evaluate their performance infrequently.
This provides a valuable insight into the problem we started with regarding the impact of COVID-19. Even though many investors have a long-term horizon, they have a short evaluation period (quarterly or even monthly). The more frequently investors evaluate their performance and shorter their time horizon, the less attractive they will find high return-high volatility investments. Investors will hesitate to buy into uncertainty of the short term for a good long-term return, mainly due to a combination of loss aversion and a short evaluation timeline. Richard Thaler calls this ‘Myopic Loss Aversion.’
Loss changes risk behavior too
There is another important implication drawn from the chart above. As there is diminishing marginal utility of gains (the curve keeps flattening), the same is applicable to losses too. The pain that an investor feels when losses increase from Rs 1000 to 2000 is very different from the pain when losses increase from Rs 100,000 to Rs 101,000. The diminishing sensitivity of gains and losses lead to change in the risk behavior of investors. They become risk averse for gains and risk seeking for losses.
Terrence Odean gave another possible explanation for such a behavior. Investors might choose to hold on to losers and sell the winners believing that today’s losers will be tomorrow’s winners. If these assessments are based on thorough evaluations, then this is a right approach. Unfortunately, experiments have shown that many a time the only reason for such a behavior is irrational expectation about short-term mean reversal (Gambler’s Fallacy).
To conclude, loss-aversion impacts the ability of the investor to take advantage of short-term uncertainty for long-term gain. It also affects the portfolio as investors frequently hold loss-making investments. Investors can reduce this negative impact by increasing the evaluation timelines. Hence, in the current pandemic, where outcomes and timelines are not clearly known, it is worthwhile sticking to the advised asset and portfolio allocation, which could be beneficial over long-term.(The writer is Head Investment Equities at Canara Robeco Asset Management)