The first in a multi-part series about a key investment issue.
In a recent blog post I introduced you to the idea of ‘behavioural investing’ – an awareness of the human biases that can often influence a client’s decision-making – and I said that I planned to examine these biases in more detail. Here goes.
Broadly speaking, these biases can be categorized into two segments: cognitive and emotional. An example of an investment-related cognitive bias is when investors are overconfident about the future and place undue importance on past investment outcomes. The disclaimer you read at the foot of advertisements for mutual funds, for example, supports this point. Emotional bias relates to the excessive influence of emotion on decision-making.
Loss aversion in action
Loss aversion is an emotional bias, where investors feel the pain of even small losses significantly more than the pleasure of equal, or even larger, gains. Research suggests that small losses hurt about 2.5 times more than a similar-sized gain brings pleasure.
This widely documented phenomenon leads to at least two behavioural patterns. First, although investors do not want to take a chance on getting rich, they tend to take chances to avoid becoming poor. The displeasure of realizing a loss by selling is so great that often the solution is to hold on in hopes the investment will turn around.
Turning around an intractable client
Behavioural researcher Harold Evensky, in his book The New Wealth Management, recommends framing as a way for advisors (like me) to help clients (like you, perhaps) escape from this predicament.
When a client proposes getting in on the next hot investment trend, the advisor’s response might be: ‘If you are right, you make a handsome profit. If you are wrong, you will need to work another three years.’
The Aha! moment
According to the logic of loss aversion, my client will make the enlightened decision and I will heave a sigh of relief. Thankfully, I’m not often required to have that kind of conversation with clients, but when I do I’m sometimes tempted to suggest they go to Vegas with the funds instead. At least this way they’ll be entertained while they lose their money!
Wishful thinking will not restore a losing investment to profitability. If the business case for an investment no longer stands up, and the probability of recovery is low (based on an objective assessment of the current facts), accept the loss and move on to a better opportunity. Sounds easy, doesn’t it? It’s not and requires rigorous discipline, which is exactly what we provide our clients.
David Ritcey, The Ritcey Team, Scotia Wealth Management, 902.678.0048