This article is originally posted on The Business Times
Imagine this: You have a choice of getting $90 or taking a 90% chance of winning $100. What would you pick? Most people would avoid the gamble and take the certain $90, even though the expected utility is the same for both options.
However, if asked to choose between losing $90 or taking a 90% chance of losing $100, you would probably choose the latter (90% chance of losing $100), and engage in risk-seeking behavior to avoid a loss. Again the expected utility of both choices is the same...
How our cognitive bias affect our judgement on uncertainty
Psychologists Daniel Kahneman and Amos Tversky developed a behavioral model known as prospect theory in 1979, to explain how our cognitive biases affect us when we assess uncertainty and make decisions using the principles of loss aversion. We tend to feel the pain of losses more strongly than the pleasure of gains. In fact, Kahneman and Tversky’s research suggests that we feel at least twice as upset about losing $100 than we feel happy if we found a $100 bill on the street.
We all believe that we are rational human beings that weigh the expected utility of different options before making a decision, but loss aversion is a cognitive bias that plays out in all parts of our lives. From staying in a failed relationship to holding onto a loss-making investment for far longer than we should, the fear of crystallising a loss feels more terrifying than keeping the status quo, even if we know that it’s costing us opportunities or money.
From an evolutionary standpoint, avoiding loss was key to survival from our hunter-gatherer days when natural hazards and threats were far and wide, and losing even a little meant putting your existence in jeopardy. Being cautious meant better odds of staying alive – and reproducing. A study conducted by Stanford psychologists and neuroscientists, where participants decided whether to gamble with actual money, showed stronger reactions in brain activity in response to possible losses than to gains – suggesting that loss aversion impacts us at a neural level.
Unfortunately, this evolutionary trait may also stop us from making smart money decisions. Let’s say you had bought 2 stocks: Stock FossilFuel and Stock RenewableEnergy. Stock FossilFuel has dropped 20% this year, and Stock RenewableEnergy has gone up by 20%. If pressed to sell one, you’re less likely to sell Stock FossilFuel and cut your losses, because doing so means realising the loss. It also means admitting that we’ve made a mistake. We’re hard-wired to avoid that feeling, and are far more likely to hold a losing stock because we believe that we haven’t lost until we sell, even if the rational side of our brain knows that the stock has no place in our portfolio and plan. In fact, you may even be tempted to double down into Stock FossilFuel in the hopes of breaking even – similar to a gambler who takes bigger bets after experiencing a losing streak.
How our loss aversion bias affect us
The loss aversion bias is also why the markets can make us feel so terrible. We have a tendency to check the performance of our portfolios too frequently, subjecting ourselves to the inevitable experience of loss days. Given that we feel twice as terrible when we experience a loss day compared to when we experience a day of equivalent gains, we’re far more likely to panic sell during sharp market declines, focusing too much on what is immediate and acutely painful, rather than on the bigger picture long-term. As Mike Tyson says, “everybody has a plan until they get punched in the mouth.” Even if we started with a well thought-out investment plan, it can be tough fighting our human emotions.
In Singapore, there is an over-reliance on cash savings to meet retirement needs because these play into our loss aversion bias. Even for those that have taken the step to contribute to SRS for retirement planning, a large portion (26%) of SRS contributions remain as cash earning 0.05% per annum. A further 1% of SRS contributions are held in fixed deposits, and 26% in insurance products. Although these options are perceived to shield us from losses, over the long-term, they are likely to lag inflation and the lower returns can hurt our chances of accumulating sufficient funds for retirement.
Interestingly, Nobel Laureate Richard Thaler’s research found that people assessed uncertainty differently when the decision was made one-off or repeatedly, and when participants were presented with the distribution of final outcomes. With only a single try, 43% accepted a gamble that had a 50-50 chance of either winning $2000 or losing $500. When the participants were told they could try 5 times, 63% accepted the gamble. Another group was presented with the distribution of outcomes for the 5-fold gamble, and the proportion of participants who chose to play increased to 83%.
Thaler applied the findings to retirement investing, where he believed that people would invest more of their retirement funds in stocks (higher risk investments) if they are shown long-term, rather than one-year, rate of returns. The average annualised rolling returns of MSCI World Index below illustrates his point, where the dispersion between best and worst returns decreases the longer you remain invested and you are statistically far less likely to experience large drawdowns.
When you see the worst 1 year return figure for MSCI World Index of -47.1% (see table above), choosing to invest in low risk financial products or staying in cash seems to be the safer choice, but it will unlikely be able to help you achieve retirement adequacy. When younger professionals make a long-term commitment to their financial future by contributing to SRS for example, they should take the additional step to be invested in the right financial products, rather than let aversion to loss impact their retirement plan. At the end of the day, our real risk is not market volatility or short-term fluctuations in our investment portfolio – it’s not achieving our goals.
All things being equal, losses fundamentally loom larger than gains. While we will always be wired to feel losses more acutely, it’s important to be aware that our cognitive biases can influence our investment behaviour and decision making, and find ways to work around it.
For example, looking at data objectively through market cycles and longer periods of time, setting an investment plan when you are in an objective frame of mind and having pre-set rules for contributing money regularly regardless of markets can help to offset hard-wired biases.
We don’t want to let emotions like fear trump reason and stop us from making smart money decisions.
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