25th July 2016 at 11:00am
When it comes to making decisions about finances, how much are we driven by wanting to grow our money as opposed to avoid losing it?
It’s a subject I’ve been thinking a lot about lately as market ups and downs grab the headlines and I look at how my own investments have fared post the EU referendum, and what I’ve heard people talking about.
Rationally, we all know markets bounce back, and things settle, with the occasional bear and bull markets in the mix from time to time. History backs this up. Yet it can be hard to focus on the potential gains we could make over the long term and not be consumed by the downturns.
It’s all down to loss aversion
It’s all down to what psychologists call loss aversion, the powerful instinct which drives much of our behaviour and influences our decisions. We’re hard-wired to be risk averse in a world where, in the words of Nobel prize-winning behavioural psychologist Daniel Kahneman, “losses loom larger than gains”.*
One US study** highlights the point rather neatly. It looked at how people behaved when offered a 5 cent bonus to re-use a plastic bag, compared to having to pay a 5 cent tax for one? In a nutshell, gain or lose.
You’d think there wouldn’t be much difference as 5 cents is only worth around 3p.
But 44% of those in the study re-used their plastic bags to avoid the 5 cent tax, compared with only 15% re-using a bag to get the 5 cent bonus.
We like winning, but we really hate to lose…
The message is pretty clear. Even when a loss is small, we dislike it more than any equivalent gain.
When it comes to investing, it applies to how many of us think and act too. We often start off cautiously because of the fear of losing out, and need some convincing to overcome our worries. This can come from seeing stock markets gain month on month, or from friends telling us how well their funds are doing. We begin to feel we’re missing out, so we overcome our reluctance and join the herd, investing to chase what are, in fact, past successes.
We expect and want to see the same high returns that tempted us in the first place. If markets fall, our immediate reaction can be one of denial. It’s just a market blip. No need to panic. If we did sell, we’d just be capitalising our losses.
But if those investments fall further, denial can turn to fear as the emotional stress of holding onto falling assets takes its toll. Rationally, we know we should stay invested, as markets tend to recover in the long term. But sometimes we just can’t hold on for better times. We give up and cash out, to prevent us losing any more.
This does give immediate relief but it can be costly. We started out reluctantly, now we’re even more so. To overcome our initial reluctance, we invested near the top and we’ve now panicked and cashed out near the bottom, just when some people are looking at it as an opportunity.
Break the cycle
The last thing we’re going to do is invest again, not unless we’re really sure we’re onto a good thing. That is, when the market has recovered. And so the cycle continues.
For some, it’s tempting to think the way out of this is not to get involved in the first place. This can be a very expensive strategy, as cash in the bank typically struggles to keep pace with inflation. The opportunity ‘cost’ of not investing could be high in the long run.
There are some ways to beat this cycle to overcome our natural instinct:
- Only invest for the long term: Investments fluctuate so you need time to ride out the storms. I think anything less than five years is too short
- Find the level of risk that works for you: There’s a whole spectrum of risk to choose from, so pick something that fits your emotional resilience. It’s wise to take a risk questionnaire to understand how much risk you’re comfortable with
- Don’t put all your eggs in one basket: By diversifying you spread investments across different asset types and geographies, so there’s less risk if markets fall and your investments should be more stable. This can help you emotionally stay the course
- Take small steps: Invest smaller amounts regularly instead of large one-offs. This way you don’t feel you’re risking as much at once. Similarly take money out gradually rather than in large lump sums. And always keep some money in cash – then you can use that first rather than realising a loss should you cash in.
Finally, much as it’s hard, try not to look at your investments too often. It can be tempting to track them closely which can emotionally “amplify” how you feel about any market movements – and get caught up in those headlines again.
The views expressed here are those of Andy Dunbar and should not be regarded as financial advice, or the views of Standard Life.
Laws and tax rules may change in the future. Your personal circumstances also have an impact on tax treatment. As with any investment, the value of a pension can go up or down and may be worth less than what was paid in. Information correct as of July 2016.
* Kahneman, D and Tversky, A (1979) “Prospect Theory: An analysis of decisions under risk”