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 🙂 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 🙂 Bear markets certainly give the media more to talk about.
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 🙂 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 1 ≠ (2-1).
In terms of behavioral finance, 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 Canadians 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 😛
To me a dollar lost has the same emotional intensity as that from a dollar gained 🙂 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 😀
Random Useless Fact: 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 🙂