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 🙂
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. 😀
Buy ALL the stocks at ALL the low prices!! 😀
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.
The human perception is quite fascinating 🙂 I’ve had my fair share of unnecessary spending too, but I’ve also learned to take a loss at face value.
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.
Investing can be very emotional. I’m still trying to understand my own personal feelings towards gains and losses when it comes to the financial markets. I’ve found that learning from my mistakes and keeping a neutral outlook on the economy helps to balance my expectations 🙂
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!
Can’t let the other poker players smell your fear lol. I can see how poker and investing have many similarities. Letting emotions get the best of you can lead to further losses.
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
People miss out on lots of opportunities because of that. Many of those who took a loss in their stocks or real estate in 2008 became terrified of investing and never got back in to the market. Unfortunate for them that just 6 years later home prices in North American on average has come back up, and the stock markets are at an all time high in the U.S. People don’t realize that selling strong, blue-chip companies, like the ones in the S&P500, during a recession is not a smart move. Buying more would have been a much better choice.
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.
Congrats on paying off your mortgage so quickly 😀 Getting out of debt can dramatically decrease your financial risk during another recession, which is only a matter of time I believe. I started investing in 2009 right at the bottom of the economic downturn so you’re right that I do not have a lot of experience with watching my stocks go down. I imagine it would be pretty nerve racking, especially when my entire portfolio would be effected and not just one or two companies I hold.
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.
Good point Steph 🙂 I think the recorded emotions may also be affected by feelings of “Darn it. I should have bought that stock for real!” 😆
[…] about risk. Opportunity would probably be the next thing I would think about. Opportunity and loss can both derive from uncertainty but financially savvy people are usually cautiously optimistic […]
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