The Fear of Losses
A new year, a new chapter, a new challenge and most importantly a new you! Investors across the world have come back from their festive family vacations and returned to work. The list of resolutions is likely to be long and optimistic. Let me guess “Stop Smoking”, “Exercise More” and the best one yet “Save More.” All well intentioned and I hope you all achieve every single one of your personal goals. In fact I hope this post helps you achieve one of them.
To the “Save More” investors, firstly I want to say well done. It is one of the most important decisions you will ever make and I hope for your sake and mine that you stick to it. So chances are you are all setting up some time to budget a bit more effectively, see your financial advisor and also re-jig your investment portfolios to attain your re-invigorated goals.
The starting point is often assessing the lay of the land since you last sat in these shoes (likely last year at the exact same time!) You are probably asking yourself: What does my existing portfolio look like?, what are all the commentators saying? And most importantly what was the winning strategy to employ last year?
So let me predict how this looks. This time last year your portfolio was not looking too bad and you had probably returned close on double digit Rand returns. That said you had just had to endure the NeneGate saga and your overseas holiday ended up costing you an arm and a leg with the Rand doing what it did over that period. To make it even worse you looked at the best performing funds for 2015 and they were mostly Global Asset funds and you were stuck in a local balanced fund of some sort. You missed out on ten to fifteen percent! Not again! So with the conviction that it could only get worse from there you sold your local balanced fund for a global balanced fund, or at least a portion of, and you had no doubt that this was the only logical decision to make!
You now are sitting in the same position this year and your now more globally balanced portfolio was negative last year while the South African market was just over 2% up in ZAR. Ouch. Time to switch it up again surely, especially with the ZAR on a tear and the world going mad!
If this is you or your advisor take a step back and breathe!
Humans are hardwired to avoid losses. Finance theory tells us that we act rationally. In order to act rationally we need to logically and accurately make decisions in the context of all available information. This is without emotion and with mathematical precision. I am talking about the kind of processing power that most rocket scientists struggle to apply consistently.
If that didn’t come close to how you make decisions then you are likely to be more human than robot. To be human is to be susceptible to error. To make decisions in a vacuum, or to frame data in a specific way, or to even make decisions emotively instead of rationally.
If you are making decisions with human error or with human behavioural characteristics then you are probably like me and most others displaying LOSS AVERSION. Loss Aversion effectively means that as humans we are hardwired to feel losses almost twice as badly as we feel when we have the equivalent gain. In other words we are skewed to REALLY avoid losses as opposed to making decisions more rationally and look at the longer term probable outcomes of the situation.
This is not a new phenomenon and has been tested academically and in practice for years. We simply hate losses more than we like gains! Losses can be absolute or relative. Most people think about loss aversion in terms of your absolute return gains and losses on individual positions in a portfolio as opposed to the portfolio as a whole.
Going back to your portfolio decision. You are probably sitting and thinking now, as you did last year this time and likely the year before that there were some investors out there last year who were better off than you were. That is probably true, but the result is that you feel a loss. You feel aggrieved by this relative underperformance. In fact you are going to try and correct that feeling by doing the winning thing. That feels far better than losing.
If I look at last year again it would have been tough to predict that the Rand would have strengthened as much as it did. I certainly would not have bet my house on Brexit occurring and even more so I would not have predicted Donald Trump being elected as the 45th US president. How wrong we all turned out to be.
Importantly though none of those feelings, emotions or predictions should impact the way you select your portfolio. The only thing one achieves from the loss aversion induced decision making is increased transaction costs, increased taxation and market timing. All the jargon comes down to one thing, stop trusting your gut on the investing front, as you are probably making a new years resolution decision that is un-doing all the benefits of your “Save More” intentions.
Instead I would do the following: spend the time on your budgeting and with financial advisor and ensure the amounts you are saving are correct. The investment world doesn’t work in calendar years let alone one year cycles. The best thing to do is ensure your investment portfolio selects the most suitable assets for your investment goal. Once that is done you need to let the story play out and not worry about it too much. As long as you are diversified both from an asset perspective and from a regional exposure perspective (in line with your goal and time horizon) you are far better served focusing your intention on the things that are really the hardest to stick to, “Exercise More” and “Stop Smoking.” At the end of the time-frame of your investment goal you are far more likely to have actually “Saved More” if you follow this logic.
I promise the price of the equities in America and property in Australia don’t really stick to calendar years nor do they really try and compete against one another the way you think they do.