Mar 132014
 

Some people have a fear of losing money. This prevents them from taking the necessary risk with their investments, like buying stocks, to give the best probability of a long term return. The S&P500 returned 20% over the last 12 months, so anyone who holds American stocks like me have probably done well with their net worth over the last year πŸ™‚ Despite reaching new record highs however, we don’t hear people talking about the stock market too regularly these days because things are going really well. But what if the S&P500 had lost 20% over that same period? I bet it would get a lot more attention wouldn’t it πŸ™‚ Bear markets certainly give the media more to talk about.

14-03-joker lose money

This is because many people can’t stand losing money. In economics the tendency to prefer avoiding a loss rather than making a gain is called loss aversion. This psychological behavior prevents many people from making smart investment decisions.

Scientists have done experiments where they give monkeys a single banana each. Predictably the monkeys would appear satisfied πŸ™‚ The scientists then gave two bananas each to another group of monkeys and then took one banana away. Note that these monkeys still ended up with a free banana each, but they become noticeably angry and agitated at the scientists, as if they had just been robbed. So sometimes Β 1Β β‰ Β (2-1).

In terms of behavioral finance, Β we’re not that much different from monkeys. We feel pretty good about getting a $20 discount on a new pair of shoes, but we feel a whole lot worse if we realize we lost $10 because it had accidentally fallen out of our pocket. But learning how to process and react to losing money correctly is important to understanding the financial system. In fact CanadiansΒ who describe themselves as more knowledgeable investors are more likely to have experienced a major loss.

Here’s an easy experiment to find out if you are risk adverse. Pick a stock to follow and imagine you own it. Record how much it has increased or decreased after each day, and your feelings about it. Over time if you notice that you feel emotionally stronger toward losses than gains of the same magnitude then this means you have a lower risk tolerance for investing, which is fine. You simply value capital preservation more than potentially larger gains. Just be aware that the time when we should be taking on the most risk is when we’re young. If our investments fail at least we would still gain valuable knowledge and experience, which we probably can’t afford to do when we’re old and crusty πŸ˜›

To me a dollar lost has the same emotional intensity as that from a dollar gained πŸ™‚ I don’t get upset if I lose on a stock trade because I know I can just as easily make it back next time. I can also sleep well at night during a recession because I know bear markets don’t last forever. Thinking about losses logically can make us more happy πŸ˜€

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Random Useless Fact:Β While sitting in front of your computer, lift your right foot and make clockwise circles.
While doing that, take your right hand and draw the number 6 in the air.
For some people, your foot will change direction all by itself. Try it πŸ™‚

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16 Comments on "Learn to Lose Money"

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Arun
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Stock market looks so high…..For those who are in the buying stage (like me), always welcome the market drop… so that we can more stock at low price. πŸ˜€

Cheap Students (@cheapstudents)
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I actually just read a bunch of journal articles on the topic of loss aversions and it’s an interesting topic for sure. The other day I was thinking of the differences between people thoughtlessly spending $20 on something they will never use and aren’t too concerned, but the thought of losing a $20 is earth shattering. It’s another way that people perceive loss in different ways, yet their horrible purchase decisions should definitely be rethought.

Phil
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Many should read it over and over and over again… Understanding your emotional attachment to money is key to an investors success. Great post. We cannot learn unless we fail. If we have not failed, we are only followers of those who tried to show us how. Practice does not always make perfect; Only perfect practice makes perfect, and when was the last time someone showed you how to get it right time and time again? – Cheers.

Marvin
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Marvin

Great point! I use to play poker before becoming a serious investor and it helped me tremendously. So many people are so scared to lose money that they just freeze and ultimately lose even more money in the process!

get rich with me
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just goes to show that so many people are not natural investors and are inclined to sell when their investments lose value and therefore incur a loss – despite the fact that its only market sentiment moving the price, and not the underlying company fundamentals

Stephanie
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Stephanie

Hm this makes sense on an intellectual level, but it’s quite another matter to go through a recession and watch your accounts drop dramatically. I remember the feeling in 2008 that this was the end of civilization as we know it. It really did feel bleak. Thankfully I did not sell anything, and rode it out, but I was definitely admiring my bond holdings believing I would never invest in equities again. I’m sure plenty of smart, level headed, non emotional investors believed something similar at the time. The events were unprecedented and the collapse seemed permanent and dire.

I’m guessing since you are quite young you didn’t have much skin in the game in 2008. I’m prepared for the corrections, but the feeling of an utter world wide collapse is quite different. Because of that time period I’m very debt-averse now. Even (especially!) mortgage debt freaks me out… At the time we had a huge mortgage and there was a very real threat during the recession of losing our home. Now the mortgage is gone and the recession is in the past, but it really changed things for me personally.

Stephanie
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Stephanie

BTW, experiments using theoretical stock watch and recording your emotions is like playing poker without betting. The emotions only come into play when real life is on the line. I.e. When you watch your actual life savings go down 30% it will terrify you much more viscerally than when the stocks on your theoretical watch-list drop. You can’t really test your emotional reactions when it’s all theoretical.

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