Investors Behaving Badly: Loss Aversion

Loss aversion is evidenced by the slope of the s-shaped curve. A loss results in greater disutility than an equally-sized gain results in positive utility. Essentially, loss aversion is a tag applied by economists to describe this unusual (and irrational) s-shape--it is the intuition behind the data. Again, this graph is not hypothetical. It is a graphical display of observed human preferences towards gains and losses when faced with uncertainty. Some behavioural economists have even estimated that losses could even be twice as harmful to our utility as gains are helpful.

In the context of investing, we derive more economic utility from capital preservation than from capital appreciation. Warren Buffet's famous rules of investing apply here: "Rule #1: Don't lose money. Rule #2: Refer to Rule #1." The insight is powerful because it reveals an inherent bias we face as investors. We are hesitant to convert an unrealised loss into a realised loss. We tend to hold on to losing investments under the hope that our original investment thesis wasn't completely off base. Alternatively, we may sell our investments too hastily for fear of realising an even greater loss if the slide continues. Notice, that our view of losses and gains relate to an original reference point (usually the price at which the investment was purchased). Comparing investments to the original purchase price (a form of mental anchoring) is a dangerous cognitive bias because it inhibits us from making sound forward-looking decisions.

So how do we use this knowledge to help ourselves become better investors? First, it is vital to understand that the centroid in the graph above (labelled "status quo") represents the decision to choose the 'riskless' outcome we spoke about last week. For investors, this means the benchmark return or investing using an exchange-traded product, or ETP (i.e. not "risking" relative under- or outperformance). The gains and losses represent an active strategy whose aim it is to outperform but, in many cases, can result in underperformance. Loss aversion, therefore, will be at its most influential, damaging, and potent to an investor's psyche when a losing active strategy is chosen over a passive strategy.

At worst, this newfound knowledge makes the investor more self-aware and perhaps gives us pause before making spontaneous investing choices. At best, the knowledge that we are naturally prone to the loss aversion bias could motivate systematic, rational investing founded in the tenets of Prospect Theory.

If an active strategy is chosen, Prospect Theory would suggest that instead of assessing the security's value in light of its past performance compared to an our original purchase price, investors should re-engage the security anew at its current price and assess its future prospects in terms of its expected excess return over the status quo. When performing this task of critical reassessment, loss aversion rears its head and we must recognise and overcome it.

In practice, this is easier said than done. And it is for this reason that passive vehicles offer investors an advantage. Investing via tracker funds or ETPs reduces the need to reassess our thesis (as it pertains to relative performance, not the basic investment thesis) because it does not demand us to recalculate the probability of beating the market, the expected magnitude of that success, and our appetite for risk. Why? Because the ETP tracks an index which, by definition, is the market we are looking to beat. For this reason, ETP investing removes much of the loss aversion bias from our investing choices because we are not expecting and should never realise excess or under performance.

Next week we look at the endowment effect, perhaps one of the toughest biases to overcome when investing.

Lee Davidson is an ETF analyst with Morningstar.