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When it comes to money, we forget mathematics
In primary school, we were taught that 100 - 100 = 0. But somehow, by the time we grow up, and the 100s in question are not just abstract numbers, but represent money, we often don't look at the equation the way we were taught elementary mathematics - because, by then, emotions take over.
Think of this situation : an investor has invested Rs.100,000 each in Fund A and Fund B. 1 year later, Fund A has appreciated by 25% to Rs.125,000 while Fund B fared poorly and is now worth Rs.75,000. The portfolio statement looks something like this :
If its not your money, you would look at the portfolio statement exactly the way its shown above. If however its your money that we are talking about, your mind would probably see the statement in this manner :
It is the loss that hits you first and stays with you, and the fact that an equivalent profit was made in another fund, is relegated into the background. While the left brain - the logical side - sees this as +25000 - 25000 = 0, the right brain - the emotional side, focuses only on the -25,000, and in fact amplifies it. Behavioural scientists call this phenomenon "Loss Aversion". We are far more averse to making losses than we are happy making gains. Research has proven that for the human mind, the pain of loss is twice the joy of gain. Put this into numbers, and you can say that while the left brain sees this portfolio statement as +25000 - 25000 = 0, the right brain's math perhaps sees it as +25000 - 50000 = -25000. Sounds irrational? Maybe. But, does it explain how most investors react to profits and losses? Perhaps yes.
Understanding loss aversion
Lets understand this concept of loss aversion a little better. If you are asked to gamble in a situation where you either stand to lose Rs.1000 or gain Rs.1000, you may not go for the gamble. If the stakes were loss of 1000 vs gain of 1500, you may still not be tempted. Raise the stakes to loss of 1000 vs gain of 2000 and some of us start getting interested. Raise it to loss of 1000 vs gain of 4000, and you have many more of us who are game for the gamble.
What has changed? Remember : the pain of loss is twice the joy of gain. When the upside potential is the same as the downside potential, we are not interested as the pain of the downside is far more than the joy of the possible upside. As long as the upside potential is less than twice the potential downside, most of us are not interested. Its only when the upside potential is much more than twice the downside risk, that we are willing to bet.
Loss aversion impacts asset allocation decisions
Loss aversion plays a critical role in influencing an investor's asset allocation decision. Most investors tend to allocate more money to assets that appear less risky. Investors have a stronger preference to avoid losses than make gains. Again, remember : the pain of loss is twice the joy of gain. When equity markets are either going down or are volatile within a wide band, they appear risky. The potential of a loss appears quite real in an investor's mind. The same market, when its trending up, and when everyone is making money around you in the market, appears less risky. Investors allocate money to an asset class when it appears less risky, not necessarily when it is less risky. Behavioural scientists have given a name to this phenomenon : its called myopic loss aversion.
Frequent portfolio reviews heighten loss aversion
Research has shown that investors who track their portfolios very frequently tend to get more anxious about the losses in their portfolios which are marked-to-market on a daily basis. This anxiety about MTM losses in turn makes them more averse to risky assets that throw up these unpleasant surprises every now and then, and over time, such investors tend to become more conservative, preferring investments that don't give them these nasty surprises, even if it means that they lose the prospect of pleasant upside surprises in their portfolios.
The flip side of this argument is that this is precisely where an advisor comes in. So long as the advisor is able to conduct periodic portfolio reviews with the objective of portfolio re-balancing to maintain agreed asset allocation, the discussions stay focused more on asset allocation rather than point-to-point near term performance of individual holdings. This process adds value to the overall investing experience. It is only when portfolio reviews are conducted frequently with the objective of evaluating near term performance of individual holdings, that the research findings are very relevant.
Loss aversion and the perceived price of safety
Loss aversion is such a strong emotion that often investors pay a huge price for the perceived safety of their investment decisions. Loss aversion causes most investors to shun any form of risk denoted by volatility, and opt for "safe" investments that very often do not preserve the purchasing power of their capital, after accounting for taxes and inflation.
It is important for advisors to understand that investors who opt for "safe" investments which destroy purchasing power in the long term, despite having a long enough time horizon, are doing so mainly because their loss aversion is higher than some others. If we are able to help them deal with this loss aversion, we can put them on the road to become successful investors. Merely saying that the client is risk averse and therefore not helping him win the war against inflation and taxes may not be in the client's best interests. Helping him understand and deal with risk, helping him understand the perils of loss aversion is perhaps going to add a lot more value in his financial life than merely faithfully accepting his loss aversion as a brick wall that cannot be surpassed.
A twist in the gamble
We discussed a gamble situation earlier, where you could lose Rs.1000 or gain Rs.1000 and we said that most of us would only opt for the gamble if the payoff on the upside was much, much larger than the potential loss on the downside. Its time for us to perhaps make a twist in the gamble.
Ask your clients which of these investment outcomes is more desirable :
» Invest 100 which grows to 250 in 10 years, or
» Invest 100 which goes down to 80 at some point, but eventually grows to 400 in the same 10 years
Ask another question about which of these outcomes is more desirable :
» Able to afford an annual holiday abroad now and for the next 25 years, or
» Able to afford an annual holiday abroad now, then a domestic one in 10 years and eventually none in 20 years
If the human mind is conditioned to look at payoffs the way it is, advisors need to use the same insight of loss aversion to show how much you really stand to lose by making sub-optimal choices today. People don't like losses and will forsake gains to avoid the prospect of a loss. If that is the case, we need to show investors the real loss from their decisions, to make them averse to the losses that really matter.
In this article, we have dealt with loss aversion and how we can help investors avoid this pitfall at the time of determining their asset allocations. In the next article, we will examine another aspect of loss aversion : which is about how investors deal with losses that are sitting in their portfolios and how you can help them manage these situations better.
All content in MasterMind is created by Wealth Forum and should not be
construed as an opinion of Sundaram Mutual Fund.
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MasterMind is a joint initiative between Sundaram Mutual and Wealth Forum, in which we offer insights into how you can become a more effective advisor to your clients, by understanding them better, understanding how they think, understanding how they take financial decisions. This gateway into your clients' minds we believe will help you relate better to them, communicate more effectively with them and thus serve them better. Mastering your client's mind is your gateway to becoming a more successful advisor. Its not for nothing that they say, "Its all in the mind!"