What I’ve Learned So Far- Chapter 3

I’m Loss Averse and Proud

By Ted Schwartz, CFP®

Well, after 25 years in the investment biz, I thought I would try to distill some of what I have learned so far (for myself and for you). Some has been learned the hard way through trial and error and some has been learned from the help of others without too much pain and suffering on my part. At any rate, I would like to offer some of what I now believe in a series of blogs that will hopefully be of some value to you.

Daniel Kahnemann and Amos Tversky developed many of the ideas of what is now called behavioral finance and Kahneman won the Nobel Prize for Economics for their work after Tversky was deceased. For a great read on the work of the two, pick up Michael Lewis’ The Undoing Project.  Richard Thaler and many others have continued to research this fascinating area, exploring how psychological and emotional factors can affect our economic decisions. One of their ideas is that many people suffer loss aversion, which is to say that the satisfaction they derive from winning (i.e. let us say gaining a dollar) is less than the pain they feel from losing a dollar.

Before Daniel and Amos began their experiments and research, the prevailing theory was known as “homo economicus” or economic man theory. The idea behind this theory was that people act rationally and with complete knowledge to maximize their personal utility. This theory has not stood up well to the research in behavioral finance, as many experiments have shown that people do not behave “rationally” in money decisions.

A simple example of behavioral finances’ point might be that we sometimes treat dollars differently and subscribe different meanings to them. A dollar inherited from your beloved and frugal grandmother may get a different treatment from a dollar that you find on the sidewalk.

At the end of the day, I think both theories are correct-we just need a very broad understanding of economic man’s “personal utility”. If we take that to measure satisfaction (emotional, physical, etc.), then it actually makes sense that all dollars are not equal.

For myself, I have had the good fortune to save and accumulate enough money to fund my future needs with a fairly limited amount of risk. Therefore, I am very loss averse and avoid taking big risks. If you told me that you have an idea that has a 60% chance of making me $250,000 and a 40% chance of losing $250,000, I have absolutely no interest in this idea. Why? The utility (satisfaction I will derive) of my having an additional $250,000 is really very small. I have little or no interest in having a more expensive car or house, so I would derive little satisfaction from having this extra money. I am happy and satisfied with my current lifestyle. On the other hand, losing $250,000 could be a potentially meaningful loss and might cause me some real pain as having that $250,000 has great utility to me. While you might say rationally that this is a good idea (the 60 per cent success rate makes it mathematically a good choice), it is not a rational idea for me to pursue as the utility of the gain is far less than the pain of the loss.

Having my investments grow at a rate of return that exceeds the rate of inflation has a very high utility to me. So, I am glad to take the risk of investments that I expect will return more than the rate of inflation. However, I am not interested in high risk, high return concepts as they do not provide utility to me.

If someone was totally destitute, they would likely see great utility in any risk that could bring them money (utility could bring them food, shelter, etc.). So, their calculus would be very different than mine in determining their level of risk aversion. As Bob Dylan put it, “when ya ain’t got nothing, you got nothing to lose”.

Our life stories, experiences, etc. will all play into how we calculate the utility of any investment decision. That is why we use Riskalyze to help determine you risk comfort level and needs, as a unique measure for you. We do not believe that two similar individuals (e.g. two 45 year-old women with no dependents and $600,000 saved) would necessarily need the same portfolios. Your life story (what has happened to you so far in life around money, your current job and your expectation of future earnings, your expected longevity, what material possessions are important to you, etc.) help us build an appropriate portfolio that is built for you and allows you to invest with a minimum of fear.