In recent years, there has been a deep and broad set of research showing us how much we think and behave irrationally, particularly when it comes to money. Our ultimate personal mastery of our relationship with money requires a deep understanding of these biases. In this series, we’ll highlight key psychological biases that we all have, and give examples of how these biases work against us. We will also cover some tips on how to overcome these biases. However, the most important weapon for us is understanding. By learning about and understanding these biases, we will be in the position to notice them in our thinking and feelings and make better conscious choices that will help us.
The first psychological bias we will cover is the fear of loss, often referred to as “loss aversion” in the literature of behavioral psychology and behavioral economics. This is a ubiquitous and extremely powerful bias that we all have. Once you own something (or feel like you do), having it taken away or seeing its value decline, is particularly painful to us. To demonstrate through a simple example, let’s consider a thought experiment.
Pretend you are part of a study on personal finance. You were chosen because you are an IBFree reader and as such, the study instructors feel confident you are much above average in personal finance skills. They provide you with the following scenario choices:
Choice 1 – The instructors offer you $75, guaranteed, with no strings attached.
Choice 2 – You can take chance to win $100. The chance of winning is 80% and if you win, you get $100 but if you lose, you win nothing.
Which choice would you pick? Why?
Most people pick choice 1 by a wide margin. On average choice 2 does get you more money at $80 (80% chance of winning $100) but you take a risk to get this higher amount.
Here is another scenario:
Choice 1 – The instructors tell you that in the fine print of the release you signed, they have the legal authority to deduct up to $100 from your bank account. In choice 1, they take $75 from you and there is nothing you can do.
Choice 2 – But they offer you another choice. In this choice they give you a chance to keep all of your money. In this case, you have a 20% chance of keeping all your money, but if you lose, then they will take $100 from you.
Which choice do you make? If you are like others (i.e. most humans), then the choice 2 gamble in the second scenario was much more appealing than it was in the first scenario. Since the math is pretty simple, you probably quickly realized the numbers were exactly the same in both scenarios. But be honest with yourself and examine how you felt about these two scenarios.
I consider myself a very rational person and not particularly emotional, but I feel similarly about this exercise than everyone else. In the benefit scenario, I chose the clear win. Taking on a pretty decent sized risk to get another $5 just seemed stupid and I didn’t have to think about my decision much. But in scenario 2, I really didn’t like the thought of someone taking my money. The chance to avoid this loss, provided in choice 2, really caused me to think about it. I started to rationalize taking the gamble. If I lose, I just lose another $25 but I’m already going to be out the larger $75 no matter what. But with the chance, I may come out with no loss at all. Despite knowing the math is exactly the same, I felt very differently about these two equivalent choices. This is completely irrational! But almost all of us do this.
It turns out, through many extensive studies and experiments, researchers have determined the degree of this irrationality. People weigh losses at 1.5-2.5 times more impactful that the equivalent benefit. So about 2x on average. It may not seem like much but it’s an absolutely huge difference!
So what are some of the effects of this strong psychological bias? If you start to look at the world with this understanding in mind, you start to notice it everywhere.
What about asking for the small drink at a fast food drive-thru even though the meal you want comes with a medium drink? You know you don’t need the calories and don’t even really want the larger drink, but you don’t save any money asking for the smaller drink. It’s essentially a “loss” to get the smaller drink so you find it difficult to ask for the smaller size drink, even if it’s what you really want.
Or what about a small ice cream for $4.25 or a medium ice cream for $4.75? You only want a small ice cream, but the price is almost the same as the medium ice cream. It feels like a loss to not get the medium ice cream “deal”. Often, stores will not even plan to sell many small sizes but price the options so that you’re directed towards the medium size that they wanted to sell you in the first place to maximize profits. If they offered a lower price on the small, too many people would choose it. If they didn’t offer it at all, people would complain about only the large size offerings. Here everyone is happy (right ?). This is a bit more about the human bias of anchoring, that we’ll cover in another post, but often these biases intertwine in our thinking and emotions.
Marketers are taught this powerful human bias to help them manipulate you. If you frame something as a loss, it will be much more powerful than if you frame it as a gain. For example, say “learn how to stop losing $100 a month of your hard earned cash on cable, with the IBFree frugal happiness guide” instead of saying “buy the IBFree frugal happiness guide and learn how to save $100 a month on cable”.
Another classic example is driving the perception of scarcity to make people feel like they are going to lose out. This takes many forms but the most common is to have a short window of time for “special sales”. The timeline adds desperation to not “lose out” on the sale. Sometimes stores will even give you “store cash” that you must spend (on something that usually costs more than the “store cash” amount of course) by a certain date. Very sneaky and very effective. People will go buy things they don’t even really want and certainly don’t need, spending more money in the process, just to not “lose” this money they feel they already own. Examine your own feelings here. Are you one of the rare types that doesn’t start thinking hard about what possible useful purchases you could make when you receive “free” money like this? I didn’t think so. Of course, if you didn’t receive this “free” money, you’d most likely have not purchased the extra items and gone on happily with your life without ever feeling the loss.
How about your job compensation? If your job has an annual bonus program, why is it only paid out after the target results are achieved? Why not pay ahead of time and then take it away if the results were not achieved? How would that feel (the numbers would be the same). If you want to be evil and use this understanding to drive harder work from your employees, set up your bonus program like this (but if you work for a company that ever does this, run for the hills!).
In fact, why have bonuses at all? In many places, bonuses are pretty standard, and designed to pay out some target amount each year. Why not just have higher salaries? Because when companies don’t earn as much, it’s extremely difficult to “reduce” wages because workers feel like they “own” those monthly paychecks and taking money away from them triggers the loss principle. Even in really tough economic times, most employers, knowing this principle, would rather reduce headcount to save money vs reducing wages for everyone but not firing.
Another interesting finding in all this research is that people value things they own more highly. Once they “own” it, the idea of losing “i.e. selling” it becomes more painful and they consistently estimate the value of these items higher than a non-emotional market price would indicate. This is true across any type of item, from coffee cups to cars to homes. It’s the main reason behind “free trial” periods for products. Once you have something, it starts to become more difficult to send it back. Plus, we are lazy and anything that requires effort on our part is less likely to happen (e.g. rebates are offered because only a small percentage of buyers will actually fill out the form and get paid).
Now, let’s get to the heart of this article, the direct connection between the fear of loss and your ability to build personal wealth. Since housing is cornerstone of net worth for most Americans, let’s start there.
One of the best examples of loss aversion is in selling your home. You envision all the memories, home improvement efforts, and positive features (many of which have a lower value to potential buyers) while minimizing the negative ones that may matter a lot to others. These emotion-based “values” that come from ownership make it more painful to “lose” by selling to someone else. This is why hiring a dispassionate third party realtor is still the most common way to buy and sell a home, despite amazingly high commission rates on such an expensive asset. From a rational point of view, the buyer and seller should be able to determine a market price and split the commission among themselves. In practice, this often breaks down because “for sale by owner” houses are listed at a higher price than an agent would list them. And remember, the agent has an incentive to list high since their fees are a % of the value. But more importantly, they need the sale to actually close so they pay attention careful to the market by looking at comparative sales.
In addition, loss aversion is also the main reason that home sales decline sharply when market values drop. People struggle to accept a lower price than they expected. The expected price could be close to a previous high point in the market, or could be anchored to the purchase price that was paid (selling a house for less than you paid is a particularly emotional type of loss). But the market price is the market price. There is no wrong or right price for your house, there is only the price others will pay for it (i.e. market price). But people would often rather stay in a house they want to leave, even if they could afford the lower value, while they wait for the market to “recover” to the point which they think is fair. Just remember, that the potential buyers out there don’t care at all about your feelings of what a fair price is and you’re paying an opportunity cost to be so emotional.
There are many interested groups that have that have actively promoted and reinforced the feeling of ownership around housing in order for people to feel more attached to their homes. The quintessential American dream. People who own and feel very attached to their homes spend more money customizing it, they keep it looking nice as they feel the pride of ownership, they lay down roots and get involved in the community, they don’t think of walking away from their mortgage even if they are severely underwater, and they are less likely to quit their job and move. These are not bad things per se, and certainly you can see why governments and companies would like these things, but just remember that you never truly own your home and land. If you stop paying your rent property taxes to the government, it won’t be long before your “owned” home is taken away from you. The feeling of loss aversion is much less strong when you think about being forced to leave the place you rent. For a home you “own”, you will make much more effort to keep it, which keeps the property taxes and mortgage payments flowing.
What about stock market investing? In my opinion, this is the most important area to understand loss aversion. It will make a huge difference in your ability to invest and manage your investments properly. I believe understanding your own (human) psychology around saving and investing and improving your behavior accordingly, will make a much, much larger impact on your net worth over time than the specific investments you choose or portfolio allocations you use.
Normally when we think about loss aversion, we think about losses, but it also means we value gains less than we should on a comparative basis so you can think about it both ways. Since gains have less of a psychological impact (especially when coupled with hedonic adaptation), the gains have to be bigger than some mental benchmark to be worth the effort or risk. One common way people think about this, is that the investment should “beat the market” to be worthwhile. This encourages risk taking to get the big gains. Ironically, the psychological bias of “loss aversion” can actually lead to undo risk taking because people shoot for excessive gains that require too much risk. So when an investment does well (meaning it did better than something else we are mentally benchmarking against), we get greedy and want to pile in for more. This is exactly the wrong time to do so since the risk to good future returns has just increased. You have to remember that study after study shows that investing in the top mutual funds for that year leads to lower performance because the gains from that year are just a single data point……they are not a trend that is sure to repeat. In fact, they usually do just the opposite. This is because the outperformance is highly likely to be just random. The detailed studies on this prove that the stories we tell ourselves to explain random outperformance are just that….stories.
As an aside, there is a lot more randomness in our world than we like to admit. Think about this. If this wasn’t the case, then rebalancing, which is clearly shown to be beneficial, would not work at all.
So what is the lesson here? Trying to beat the market is being too greedy. Regular market returns over time are generous and you’re taking enough risk to get those so assemble a collection of low fee index funds and be happy to get a market return, knowing that you are outperforming almost every individual and institutional investor who is trying to beat the market.
What about losses? This is the place where loss aversion become very clear, very powerful, and very harmful to your wealth. When things start going south, fear kicks in at a gut level. We are back to being monkeys running from a lion. We hold at first, fighting our fears, knowing we shouldn’t panic. But eventually the pain becomes too much and we finally sell, just to avoid any further pain. Then, when things start to turn around, as they always do, the fear of further loss (combined with recent events bias where we emphasize recent events more strongly than past ones), makes us want to be more sure the bleeding has stopped before we jump back in. But the big gains are made quickly, at times when all the news headlines and company financial results are poor. By the time you start to believe the recovery is real, the big gains have already been made.
This fear is what directly causes us to sell low and buy high. It’s important to note here that when I say buy high, I don’t mean that most people aggressively buy at the tops of markets, although that happens. More importantly, they are not in the market at the low points and only get back in after much of the initial run up happens. So they buy back in much higher than the bottoms of the market. I don’t have clear data on this particular point but I suspect this is the biggest reason individual investors lag market returns by a substantial amount. So what is the lesson here? Remember that people weight fear two times more than gains. So when you are trying to balance fear and greed, err on the side of greed because your fear is heavily weighted in your thinking and emotions. Warren Buffet’s most famous quote is to “be fearful when others are greedy and greedy when others are fearful”. What isn’t mentioned next to this quote is that Warren isn’t very fearful. When he buys, he buys for the long haul and doesn’t sell based on market declines. In fact, he rarely sells at all. He just builds up cash that his businesses are generating and invests it when he finds good bargains. And when everyone is scared and selling, he is working hard, fearlessly buying investments at an aggressive pace.
Another challenge with losses is the desire to not sell them simply because people don’t want their “paper” losses to become real. Your choice should be based on your estimate of what your investments will do in the future, starting with where the investment stands at the moment. Typically, this means that the investment you thought was good when you owned it before, is an even better investment for the future if you were buying it now, since future returns are estimated based on the price you are paying for a given future earnings stream. In other words, the money you expect in the future from your investment is even more certain now because your investment is on sale compared to when you first bought it. You may want to put more money into it, at least if it’s a diversified index fund (it’s a much harder decision for individual stocks). However, we haven’t covered taxes yet. Taxes, over time, can make a very big difference in the returns you get. So if you need some cash, and are sitting on losses, it’s generally a good idea to sell the losses and lower your taxes. Even if you want to buy more after a decline, sell what you have to claim the losses and lower your basis, wait 30 days to avoid the IRS wash sale rules, and then buy back into the investment. Selling losses, and riding gains, is a well-established method of improving your returns. When individual investors need cash, they tend to sell their winners and hang onto their losses because it “feels” better to do so, but just based on taxes this is usually the wrong thing to do.
So how do individual investors fare overall? Many try to beat the market, trading too much or paying high fees which reduces their returns. More importantly, loss aversion causes most investors to sell during declines and this is what really hurts their returns. Based on data collected by Dalbar Inc, that studies investor behavior and returns, individual investors achieved a 5.19% return over a 20 year period ending 12/31/15. The broader market indexes returned 9.85%……….nearly 2x!!!! This is a huge difference, especially considering this is a year after year difference over a long period of time. The difference in wealth at the end is quite large. As an example, if we start with an investment of $100,000, a 5.19% return after 20 years yields about $270,000. If we assume a 2.5 % inflation rate during that period, this is a gain of about $110,000 over inflation. Not bad, but the 9.85% return generates a final value of $650,000, $480,000 above inflation or about a 4X improved wealth gain! Just by being a buy and hold investor you would improve performance significantly over what most individual investors achieve.
Important side note here; your investment returns really only matter based on how much they are above inflation and fees since all of these numbers are compounding numbers. So a quick way to see your return multiple on your money is to take your return and divide by inflation + fees. Assuming minimal fees (e.g. low cost index funds) a ~5% return is about 2x inflation in this case. In inflation adjusted terms, you have doubled your money in this 20 year period. An 8% return is 4x inflation here, leading to a quadrupling of your wealth instead. This is why low return investments like bonds at the current time are not very attractive, and putting your cash in things like savings accounts or CDs that return less money than inflation are a pure disaster over any length of time. It also helps explain why focusing on fees is critical over long periods, especially now that lower investment returns are forecast. If you’re assuming a 4% return over inflation for example (in line with many forecasts right now), a 1% investment fee reduces your net returns by 25%! Again, it’s critical to understand that inflation, management fees, and investment gains are compounding numbers, which makes them harder to grasp for people, and makes them both very powerful and very important to understand.
As another investing example, on Wall Street, investment managers can get desperate when their investments lose money and clients get scared and start redeeming their money. This forces managers to sell investments to generate the cash to pay these exiting clients. This can lead to a snowballing effect of selling, even bringing the entire market down if the herd behavior takes hold. In fact, almost all bust cycles go below a reasonable valuation level before they bottom out because of this strong psychological bias. This is why “value” investing styles have outperformed “growth” styles over time. And it’s great to remember that because of the way people think and act together, markets almost always overcorrect at the bottom. It’s very difficult if not impossible to know if you’re at the bottom during a downturn or if there are more losses to come, but if you’re not sure whether you want to invest aggressively or not, err or the side of being aggressive if the market is already down quite a bit. Even if it goes down farther, it likely to come back up quickly, but it might go back up sooner than you think as well, and you’d miss out on those gains.
So where does this leave us for investing? My general advice for most people is to err on the side of being aggressive investors using low cost index funds and to buy and hold. Invest a larger portion of your net worth in stocks. Diversify across small and large stocks as well as domestic and foreign. Do not sell when the markets go down. If you haven’t already sold on the way up, it’s likely too late now. If you did sell, you could likely avoid some of the further losses, but the main problem is that usually you will not get back in quickly enough once a decline starts. After a big decline, gains usually happen quickly and almost everyone that gets nervous and sells, waits too long to get back in. Remember that all the financial statistics and company finances are usually still poor when the market runs up…..wait to be sure the economy is improving means you’re too late. Investors that do this, especially looking at popular press or TV headlines would have made a lot more money by just holding their investments through the painful declines. This is what the data proves.
On a personal front, I have learned to be comfortable with being aggressive, partly by better understanding how I and everyone else are predictably irrational when it comes to investing and fear vs gains. Our intuition tells us to be more conservative than we should be. In this case our intuition is wrong and very costly.
As you become more advanced as an investor, you can start to make independent choices on specific investments to better refine your asset allocation and make bets on particular opportunities. However, the core of your investment portfolio should be a set of low cost index stock funds that you keep forever.
If you’d like to learn more, I highly recommend reading Thinking Fast and Slow by Dan Kahneman. He is a psychologist by training but won the Nobel prize for his leading work in active field of Behavioral Economics. The book is filled with great examples of irrationality with money and insights into how all our minds work. Better understanding of how our own minds work will help you make better decisions for yourself when it comes to saving and investing…….helping you achieve financial independence faster if you put this knowledge to work.
Another great book on the same topic is by Dan Ariely. It’s not as comprehensive as Kahneman’s book but it still covers many examples and provides insights into how are minds are irrational, but in a consistent way that we can understand so that we can use this awareness to make better decisions.
Personal disclosure: I personally have more invested overseas than most, particularly in emerging markets, and I also use “macro” analysis to make asset allocation shifts depending on where in the business cycle we are and where I believe there is more cyclical value. However, it seems I am more comfortable than most with taking risks and don’t mind when my views are at odds with the current investing themes. My current investing theme hasn’t helped me these last few years and the current Brexit isn’t helping much either. It’s quite possible I should be taking my own recommendation. However, I am still comfortable when my wealth declines sharply as stocks decline. As an example, I didn’t sell any stocks during the financial crises and bought more on the way down with any dollar I had available. I still believe that multi-year cyclical portfolio shifts based on valuations can add a bit to a core portfolio of market cap weighted broad market funds. But it’s not easy and probably isn’t worth the effort (I just happen to find it a fun hobby).
I have also currently have sold some stock investments, particularly in the US where I believe valuations (prices) are high compared to earnings. The US stock market has done very well over the last few years and I’m hesitant of getting too greedy. In contrast, my emerging markets investments have not done well (i.e. are even more attractively priced for good future returns now). I see no compelling structural theme that indicates the broad set of emerging markets will not improve business results in the future so I have shifted more of my portfolio to emerging markets index funds. Having said that, during declines, most markets have become heavily correlated, so if US stocks decline, it’s highly likely that global stocks will decline as well, providing an even more attractive investment opportunity for me in emerging stocks.
Since I’ve made good gains during the last bull cycle, and various indicators show we are at a late stage in the bull market (meaning it could end soon or could end still 2-3 years from now), I’ve currently shifted 20% of my net worth to cash. The remaining 80% is still fully invested in stocks however since nothing is certain and being aggressive with investing is clearly the bias that pays off over time. Update: I wrote this before the Brexit vote and have already put some of this cash back to work in stocks. I’m hoping for more declines to get back into stocks and out of cash! I’ll put 50% of my cash back in if the market drops by 10% from the peak and the rest if the market drops 20%, even if it seems like it’s going to keep going down.
I could certainly be wrong in my personal investing analysis and I recommend a more conventional, but aggressive asset allocation to most people, biased towards heavy stock ownership since “retirement” funds need to last longer now than they used to, especially if you’re also looking at an early retirement. I’m comfortable doing some different things with my own portfolio but it’s a personal choice and carries risk that I’m willing to take. After all, a key part of this blog is about the freedom to choose what you do 🙂