Losing feels bad more than winning feels good

I’m about to flip a coin, and you get to call heads or tails. If you lose, you have to pay me $1,000. Question: If you win, how much would I have to pay you to make it worth the risk?

Your odds of success are exactly 50-50, so in theory you should be willing to settle for $1,000. But something tells me you’d need a bigger payoff, a lot more than $1,000. Maybe as much as $2,000.

That’s not rational, of course, but neither is the average human being. Losing money – or practically anything else – makes us feel bad a lot more than making the same amount of money makes us feel good, perhaps up to twice as much. Psychologists Daniel Kahneman and Amos Tversky discovered this anomaly and called it loss aversion, which was the central concept behind their prospect theory, which is the foundation of what we now call behavioral economics. It also won Kahneman the 2002 Nobel Prize in economics.

Loss aversion helps explain why a 10% drop in the value of your portfolio makes you feel up to twice as bad as a 10% gain makes you feel good. Behavioral economics helps us realize that the zigs and zags of portfolio values aren’t nearly as important to your financial success as how you respond to them. In other words, it isn’t investment performance that determines our results as much as it is our own investor behavior.

But here’s the problem. The types of investments that have historically provided the best results in the long run – namely, stocks – are the same ones most likely to disappoint us in the short run. How can we overcome our loss aversion in pursuit of better investment returns?

The key, I believe, is understanding the importance that time should play in your investment decisions. If you need money from your portfolio to help finance your retirement spending over the next twelve months, that money should not be invested in stocks, despite their higher return potential. The S&P 500 lost more than a third of its value as recently as 2008, and in any calendar year, temporary losses of 10% or more are the norm. In the short run, loss aversion is rational behavior.

Over the long run, however, loss aversion will likely result in unnecessarily low returns and thereby prevent you from fully achieving your financial goals and dreams. Volatility is a short-term phenomenon that tends to dissipate with time and patience. And long-term investment success requires not avoiding investment volatility and loss, but tolerating it.

Daniel Kahneman died recently at the age of 90. And true to form, as much as his discoveries have helped us all as investors, losing him will hurt us even more.