The spectrum of possibilities for investments are anchored on one end by the potential of “making a killing” and on the opposite end by “losing everything”. The object of course is to avoid the latter and have some of the former. These possibilities are, however, not equal. For the most part, your investing experiences will be on the positive side of the spectrum (ignoring short term volatility of course).
One of my early mentors used to say “the downside hurts more than the upside helps”. Little did he know that this adage would be borne out in the academic research over the ensuing years. The emotion of regret cuts both ways. You might regret not buying an investment at an earlier time and try to buy now once it has run up in value. Conversely, you might regret having bought a particular investment that has declined in value. In both cases, the key is to avoid acting upon regret.
As many of you know, we use the change in your overall net worth as a point of focus in our planning meetings. Changes in wealth can be more important to clients sometimes than levels of wealth. Professor Daniel Kahneman, who was awarded the Nobel Prize in Economics, says “human beings feel and fear loss much more than they enjoy gain”. Since wealth preservation is a common core objective, clients sometimes place more emphasis on changes than levels of wealth.
The way loss aversion manifests itself for many investors is by constantly searching for investments that appear to possess low volatility yet have good returns. The video that we recorded last year around this time “Tastes Great, Less Filling” speaks directly to this delusion.
In essence, many investors are searching for “unicorns”, mythical creatures that have been described since antiquity but don’t actually exist. The reason stocks returns are higher than bonds over time is directly related to volatility. You are being paid for this volatility. If returns were stable (less volatility), the returns would be lower. Ready for a real conversation?