when it comes to money we forget mathematics myopic loss aversion
When it comes to money, we forget Mathematics
In primary school, we were taught that 100 - 100 = 0. But somehow, by the time we grow up, and the 100s in question are not just abstract numbers, but represent money, we often don't look at the equation the way we were taught elementary mathematics - because, by then, emotions take over.
Think of this situation: Someone has invested Rs.100,000 each in Fund A and Fund B. 1 year later, Fund A has appreciated by 25% to Rs.125,000 while Fund B fared poorly and is now worth Rs.75,000. The portfolio statement looks something like this:
If its not our money, we would look at the portfolio statement exactly the way its shown above. If however its our money that we are talking about, our mind would probably see the statement in this manner :
It is the loss that hits us first and stays with us, and the fact that an equivalent profit was made in another fund, is relegated into the background. While the left brain - the Logical side - sees this as +25000 - 25000 = 0, the Right brain - the emotional side, focuses only on the -25,000, and in fact amplifies it. Behavioural scientists call this phenomenon "Loss Aversion". We are far more unhappy making losses than we are happy making gains. Research has proven that for the human mind, the pain of loss is twice the joy of gain. Put this into numbers, and you can say that while the left brain sees this portfolio statement as +25000 - 25000 = 0, the right brain's math perhaps sees it as +25000 - 50000 = -25000. Sounds irrational? Maybe. But, it explains how most investors react to profits and losses!!Loss aversion impacts asset allocation decisions
Most investors tend to allocate more money to assets that “appear” less risky. Investors have a stronger preference to avoid losses than make gains. When equity markets are either going down or are volatile within a wide band, they appear risky. The potential of a loss appears quite real in an investor's mind. The same market, when its trending up, and when everyone is making money around us in the market, appears less risky. Investors allocate money to an asset class when it appears less risky, not necessarily when it is less risky. Behavioural scientists have given a name to this phenomenon : its called Myopic Loss Aversion.Frequent portfolio reviews heighten loss aversion
Research has shown that investors who track their portfolios very frequently tend to get more anxious about the losses in their portfolios which are marked-to-market (MTM) on a daily basis. This anxiety about MTM losses in turn makes them more averse to risky assets that throw up these unpleasant surprises every now and then, and over time, such investors tend to become more conservative, preferring investments that don't give them these nasty surprises, even if it means that they lose the prospect of pleasant upside surprises in their portfolios.
Loss aversion and the perceived price of safety
Loss aversion is such a strong emotion that often investors pay a huge price for the perceived safety of their investment decisions. Loss aversion causes most investors to shun any form of risk denoted by volatility, and opt for "safe" investments that very often do not preserve the purchasing power of their capital, after accounting for taxes and inflation.