For most of us, when markets go down, anxiety goes up.
And since markets haven’t gone down substantially for some time, it’s possible that angst is waiting in the wings for a lot of us and could be set loose by the next downturn.
I am not anticipating an imminent demise of the bull run in stocks. But after two great years of returns, it’s important to remember that corrections are normal occurrences.
On average, we can expect stocks to drop 14% from recent peaks in any given year, according to research from JP Morgan Asset Management (recoveries typically follow closely on the heels of these declines).
And it’s important to remember that we as humans are hard wired to disproportionately fear financial losses relative to appreciating similarly sized gains.
We obviously can’t control what happens in the financial markets. But we can control how we respond to financial market developments.
The goal of this article is to provide more information about the concept of loss aversion; explain how it affects investors; and share strategies to overcome it.
Learning to become averse to loss aversion is a strategy that should yield positive results over the long term for your portfolio.
What is Loss Aversion?
Loss aversion is a key principle in behavioral finance introduced by Daniel Kahneman and Amos Tversky in Prospect Theory. Our friends at research outfit DataTrek have this to say about Loss Aversion:
- Classical economics has it that the gain or loss of $1 has the same “utility”, both on the upside and downside.
- Daniel Kahneman and Amos Tversky proved this was not the case with their work on Prospect Theory, published in 1979, with Kahneman winning the Nobel Prize in 2002.
- The possibility (or “prospect”) of losing a particular amount of money weighs about twice as heavily on the human psyche as the prospect of gaining that same amount of money is welcoming.
- Simply put, we are hard coded to be risk-averse, which is probably biologically optimal but not when it comes to investing.
This asymmetry – that people experience the pain of losses about twice as intensely as they experience the pleasure of equivalent gains – can lead investors to behave irrationally, often making suboptimal decisions due to an emotional response rather than a rational evaluation of risk and return.
How Loss Aversion Affects Investors
- Excessive Conservatism: Investors may hold too much cash or invest heavily in low-risk assets, such as bonds, due to an outsized fear of losses. This risk aversion can cause them to miss out on long-term market growth.
- Holding onto Losing Investments Too Long: Investors often refuse to sell losing stocks because doing so would “lock in” a loss. This can lead to further declines in portfolio value if the asset continues to underperform.
- Selling Winners Too Soon: The fear of losing unrealized gains can prompt investors to sell winning stocks too early, limiting their upside potential while holding onto losing positions in the hope of a rebound.
- Panic Selling in Downturns: During market downturns, loss-averse investors may sell off assets at a loss to avoid further perceived pain. This often results in missing out on the subsequent recovery.
Strategies to Overcome Loss Aversion
Investors can take several steps to mitigate the negative effects of loss aversion.
- Maintain a Long-Term Perspective
- Historical Context:Market downturns are normal and historically temporary. The S&P 500, for instance, has endured numerous recessions, bear markets, and crashes but has always recovered over time.
- Review Past Recoveries: Looking at previous downturns (e.g., 2008 financial crisis, 2020 COVID-19 crash) can provide reassurance that patient investors tend to be rewarded.
- Avoid Emotional Decision-Making
- Recognize Emotional Triggers: Fear and anxiety can drive investors to sell at the worst possible time. Understanding that these emotions are natural but not always rational can help maintain discipline.
- Pause Before Making Major Moves: Implement a 24- or 48-hour rule before making significant financial decisions to avoid impulsive reactions.
- Stick to a Predefined Investment Plan
- Set Portfolio Rules in Advance: Establish clear rules for buying, selling, and rebalancing to avoid making decisions based on market noise.
- Use Mental Accounting to Categorize Risk
- Investors can separate their portfolios into different “buckets,”such as:
- A short-term stability bucket (cash, bonds) for near-term needs.
- A growth bucket (stocks, real estate) for long-term wealth building.
- This mental separation reduces the fear of short-term lossesaffecting immediate financial security.
- Rebalance Rather Than Panic-Sell
- Automatic Rebalancing:If stock prices fall, rebalancing forces investors to sell overperforming assets (like bonds) and buy underperforming assets (stocks) at a discount.
- Stay within Target Allocations:Keeping the portfolio’s stock-to-bond ratio aligned with the original strategy ensures disciplined investing.
- Use Dollar-Cost Averaging (DCA)
- Invest Regularly Regardless of Market Conditions: Investing a fixed amount regularly reduces the emotional burden of market timing.
- Buy More Shares at Lower Prices:Instead of fearing lower prices, DCA allows investors to accumulate more shares when prices are low, boosting returns when markets recover.
- Maintain Cash Reserves
- Emergency Fund:Having 6–12 months of living expenses in cash reduces the need to liquidate investments during downturns.
- Dry Powder Strategy:Investors who keep some cash on hand can take advantage of market downturns by buying assets at depressed prices.
- Diversify to Reduce Portfolio Volatility
- Asset Allocation: Spreading investments across stocks, bonds, real estate, and alternative assets helps mitigate losses.
- Low-Correlation Assets:Investments like Treasury Bills and Treasury bonds can provide balance when equities decline.
- Avoid Market Timing
- Missing the Best Days Hurts Returns:Data shows that missing just a few of the best market days (which often occur after the worst days) significantly lowers long-term returns.
- Stay Invested:Rather than guessing market bottoms, staying in the market increases the likelihood of benefiting from recovery.
- Turn Market Declines into Tax-Saving Opportunities
- Tax-Loss Harvesting: Selling losing investments to offset capital gains taxes can improve after-tax returns.
- Roth Conversions:Converting traditional IRA funds to a Roth IRA during downturns allows investors to pay taxes at lower asset values, leading to greater tax-free growth.
The key to overcoming loss aversion during a market downturn is sticking to a well-thought-out plan, staying diversified, and avoiding knee-jerk reactions.
Implementing these strategies can help you manage their emotions, take advantage of market opportunities, and build long-term wealth.
-RK