Loss Aversion (2008-03-03)

Loss Aversion

(2008-03-03) by David John Marotta

Even with a brilliant investment plan, it takes diligence to overcome our emotional biases and avoid making investing mistakes. Here is the wisdom that both advisors and investors need to bear in mind to avoid succumbing to the fallacies of behavioral economics.

It doesn’t take extensive research to determine that we are much happier when our portfolio values go up. When they go down even slightly, however, we are tempted to make poor choices. To avoid these unfortunate choices, we need reassurance and a sense of how our instincts can deceive us.

The tendency to experience significantly more discomfort with slight losses than to experience happiness with large gains is called "loss aversion."

Psychologists suggest we feel a loss about 2.5 times as much as an equivalent gain. That means if you see an equal number of ups and downs, you feel miserable. You feel some pleasure when the markets move up and a great deal of pain when the markets move down. But most of the daily and weekly fluctuations in the markets are just random noise.

Therefore, the more frequently you look at the markets, such as daily or weekly, the more discouraged you get. And even if you have a well-crafted investment strategy, you may be tempted to make changes in order to alleviate your suffering. Every study shows that loss aversion actually causes greater than average losses.

Consider that over the past decade, the daily movement in the markets was positive only 52% of the time. That means if you watched the markets every day, you were content on 190 days and despondent on 175 days. Because you grieve the down days 2.5 times as much as you celebrate the positive ones, on the average day you’re glum, and instead of remembering the reality that the markets dip 48% of the time, you feel as if they go down 70% of the time.

If you only look each week your odds of happiness rise slightly to 54%, but your misery remains low, still feeling like they go down 68% of the time. The monthly odds of happiness are 62%, but you still like they go down 64% of the time. Quarterly returns go up 68% of the time, but your average emotions tell you they only go up 55% of the time.

Even though the vast majority of calendar quarters in the market are positive, it is the shortest time period in which, on average, we won’t be disappointed. Only if you can refrain from looking at the markets for an entire year, will you be more likely to feel satisfied. Annually you get happy news 77% of the time, although you only perceive it as 62%.

These are the best case scenarios, assuming you have an outstanding investment plan. You may feel much worse whether you have a poorly designed portfolio or a well-designed one. Here’s why.

A poorly designed portfolio is typically laden with fees and commissions, putting a drag on your returns. It may also be inadequately diversified and oscillating with an even higher noise-to-performance ratio than necessary. In this case, your odds of happiness are slim indeed.

But even if you have a well-designed portfolio, your may feel unsettled. Being diversified means always having something to complain about. You must recognize the difference between a poorly designed portfolio and a well designed portfolio. You must know when to heed the warning signs and when to ignore the noise.

If you own a handful of mutual funds that are commission-based A, B or C shares, you probably have a reason to be discouraged. If that is the case, first set a diversified asset allocation that has the best chance of meeting your goals with a fiduciary financial advisor who sits on your side of the table. And second, relax and enjoy life 364 days out of each year.

from http://www.emarotta.com/article.php?ID=273

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