What was the going rate for a Cornell University coffee mug on the 1991 open market? According to a landmark Journal of Economic Perspectives study, study group participants trying to sell the mug valued it at $7; those thinking of buying one set the price at $3. In real life, the mugs were selling for $6 in the campus bookstore.
According to a recent presentation by one of the study’s authors, Daniel Kahneman, a psychologist who won a Nobel Prize in economics, the disparate pricing was the result of a behavioral trait known as the endowment effect. This effect caused sellers to over-value their “bird in the hand” while buyers under-valued the bird in the bush. The endowment effect is, in turn, part of a larger tendency known as loss aversion or in Professor Kahneman’s simple summation, “People don’t like giving up things.”
Our shared loss aversion means that we tend to fear and be pained by losses more than we look forward to or are gratified by rewards. As Harvard psychologist and “Stumbling on Happiness” author Daniel Gilbert describes in his book, “Most of us would refuse a bet that gives us an 85 percent chance of doubling our life savings and a 15 percent chance of losing it. The likely prospect of a big gain just doesn’t compensate for the unlikely prospect of a big loss.”
Beyond academic mind games, when loss aversion is allowed free rein over your investment decisions, it can wreak real havoc on an otherwise rational strategy. Here are a few examples:
Succumbing to sunken costs – Even though it’s no longer serving its planned purpose in your portfolio, you hang onto an investment because it has declined in value. You tell yourself you don’t want to unload the albatross until it’s at least recovered its footing, if not taken flight. The problem is, the depreciated holding may never recover and, meanwhile, you’re losing out on making better use of the tied-up funds. The more advisable course is to buy and sell according to a well-reasoned and disciplined plan.
Wracked by regret – You may also experience a forward-thinking loss aversion, aka regret, when you don’t own a hot stock or sector on the rapid rise. As described in coverage of Professor Kahneman’s presentation, “That’s why so many investors, having seen an investment rise in value, will seek to buy that investment after it’s had its run. It’s also why, as research has shown … investors will far too often buy into and get out of funds, to their detriment.” In other words, as an investor, it’s okay to feel regret, but acting on it means you’re chasing yesterday’s spilled milk returns instead of positively positioning yourself for tomorrow’s possibilities.
Cringing from perceived pain – A final example of loss aversion is its impact on your assessment of investment risks and rewards. Your gut already tells you that a bad outcome is going to feel worse than a good one will feel great. As a result, you may not be as willing to build market risk and its expected returns into your portfolio, even if your logical financial plan indicates it will help you achieve your goals.
That said, the most logical level of risk and reward for your portfolio may not be the right level for your personal well-being. If loss aversion is going to cause you to panic and alter your logically laid plans when market risk appears, your best course may be to ratchet down the risk exposure to begin with, accept slightly lower than expected returns, and make up for it elsewhere in your planning (by spending less, saving more and/or earning longer etc.). The best overall plan is the one you can stick with through thick and thin.
Being on Our Best Behavior
As Professor Kahneman and others have helped us understand, market pricing and many other facets of investing are often explained as much or more by behavioral finance as by an object’s intrinsic worth or an investor’s rational decisions. Familiarizing yourself with loss aversion and similar traits won’t cause the emotions to disappear. You’ll still feel them, but if you can recognize them when they’re occurring, you stand a better chance of ensuring that they don’t over-influence your actions. An impartial advisor familiar with the traps laid by behavioral finance can also help you avoid falling prey to their wily ways.