Expert’s Choice: Avoiding the losses and losing the wins

Since the 18^th century, the foundation of economic theory was that humans assessed losses and gains equally. It has only been in the last 50 years, or so, that behavioural economists and psychologists have proven this is not the case.

This fundamental flaw in economic theory has been exposed because:

1. the old theory fails to allow for different reference, or starting, points;
2. humans are more sensitive to reductions in wealth than increases; and
3. feelings such as regret were not considered.

Behavioural economist Richard Thaler and psychologist Daniel Kahneman have both been awarded Nobel prizes for their research into the behaviour and decision-making processes of humans and the role of these processes in understanding the broader field of economics. Understanding their findings about reference points, loss aversion and regret can help the investment industry counsel their clients through one of the most turbulent markets in history.

Importance of a reference point

To highlight the importance of a reference point Kahneman, in Thinking, Fast and Slow, uses the following example. He uses the monikers, Anthony and Betty.

Anthony currently has $1 million, Betty $4 million.

They are both offered a choice between a gamble and sure thing. The gamble is they will either end up with $1 million or $4 million. Doing nothing and accepting the sure thing is to own $2 million.

The theories that underpin most economic principles assume Anthony and Betty will make the same choice. This is because the theory does not consider the reference points that Anthony and Betty start at and will consider when making their decision.

Anthony who currently has $1 million will double his wealth with the sure thing. This is attractive. Alternatively, he can gamble with equal chances to quadruple his wealth or end up where he is now. The gambling choice is risky for Anthony.

Betty, on the other hand, will almost certainly baulk at the certain $2 million outcome because that means she will lose half her wealth. Alternatively, she can gamble and lose three quarters or retain her $4 million.

You can see that Anthony and Betty are going to make different choices.

The different reference points make the ‘sure’ outcome good for Anthony and bad for Betty.

You’ll note, Betty, faced with a loss, now becomes a risk-seeker. This underpins Prospect Theory, people seek risk when all the options are bad. It sounds counterintuitive but it’s true.

Prospect Theory or the human response to losses is stronger than to gains

Consider these two problems (again, these are summarised from Thinking, Fast and Slow)

1 – You have been given $1,000.
You are now asked to choose one of these options:
50% chance to win $1,000 OR get $500 for sure

Or

2 – You have been given $2,000.
You are now asked to choose one of these options:
50% chance to lose $1,000 OR lose $500 for sure

The ‘sure’ outcome to both problems is $1,500. Most people are risk averse in problem 1 and accept the sure $500. However, in problem two, they are more likely to gamble, even though the probability is high that they will lose $1,000 not $500.

What researchers discovered was that, when weighed against each other, losses loom larger than gains and humans will do all they can to avoid losses. This a principle of Prospect Theory. According to Kahneman this process has an evolutionary history, “Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.” This might have helped us in the wild, but its results in the investment world vary. Investors must evaluate and assess start-ups, company results and future prospects each with uncertain outcomes.

The options investors face every day involve a risk of loss and an opportunity for gain. We generally do not like to accept the risk of losses. For example, Behartzi and Thaler (1995), pondered why individual investors continued to shun stocks even though their real returns had been about 7% per year since 1926. They attempted to determine what ‘premium’ people would accept to consider this higher returning option, which could incur short-term periods of losses. Behartzi and Thaler found individual investors were “unwilling to accept return variability even if the short-run returns have no effect on immediate consumption.”

Behartzi and Thaler made reference to ‘organisations’, to test if they too were loss averse. They found pension and endowment funds were also susceptible to loss aversion, but that they were however were more likely to have significant exposure to growth assets given the long-term nature of their investment objectives.

Of course, back in 1995 when Behartzi and Thaler wrote their paper, many people were not yet exposed to long term investing for pensions. The superannuation guarantee had only been introduced in Australia three years prior. Since then share ownership has increased. Australian investors, via their superannuation, have become more comfortable with the volatility that comes with stock market investing.

Given this increased level of comfort to save for the long term in their super, we wonder if Behartzi and Thaler did their research today in Australia, would they find a change in the level of risk aversion? Are Australian investors riding the current market falls, focused on their long-term investment goals? How do they feel when they look at the news?

What Behatzi and Thaler’s models, as well as Prospect Theory, fail to allow for is disappointment and regret.

That feeling of regret

Regret has been defined as “the pain we feel when we realise that we would be better off today if we had taken a different action in the past.” When you are investing, you are exposed to possible future regret and people take this into consideration when they decide to allocate their money to an investment. This can lead to a process that behavioural economists call ‘narrow framing’. Barberis, Huang and Thaler (2006) found that narrow framing is a more important feature on decision making than previously realised especially when the outcome could lead to regret. Narrow framing is the process of using information that most accessible. For example, it is natural in the current market environment, to consider short-term returns. Unfortunately, losses occur more often in risky assets when short term returns are considered, and for investors allocating to these risky asset classes this could lead to potential regret should losses occur and the gamble turns out poorly.

Alternatively, the regret could be missing gains.

This is where information filtering is paramount. Daily exposure to newspapers, books and online media with information about stock markets and bonds is accessible to everyone. In Australia, all working Australians are investors through the superannuation guarantee and their superannuation funds. We think over time this will continue to lead to superior decision-making and active participation in markets by all Australians.

It’s important to look past the positive and negative commentary and concentrate on long term goals. Successful long-term investors survive short-term falls by sticking to investment principles that have withstood the tests of time. For portfolios, this may include better diversification. For equities, investing in profitable companies with strong balance sheets and stable earnings has historically given resilience to portfolios.

Our CEO, Arian Neiron wrote in the AFR this week, “Bear markets are the ultimate behavioural test for investors. The outcome of this test says more about their likelihood of success in building wealth over the long run than does the direction of financial markets. Investors will either stay smart or yield to emotion, which can ruin the potential for gains.”

Hopefully, if you are aware of human behaviours and biases, you can be better investors. The behaviours and biases outlined above are by no means the only ones that affect investment decisions. We will outline more of these in a future Experts Choice.  

A version of this article was originally published in April 2020 as the stock market fell due to COVID-19 lockdowns.

References:

Barberis, Nicholas; Heung, Ming; Thaler, Richard H. (2006). "Individual preferences, monetary gambles, and stock market participation: a case for narrow framing". American Economic Review. 96 (4): 1069–1090
Benartzi, Shlomo; Thaler, Richard (1995). "Myopic loss aversion and the Equity Premium Puzzle". The Quarterly Journal of Economics. 110 (1): 453–458
Kahneman, D. (2011) Thinking, Fast and Slow, United States, Farrar, Straus and Giroux