Doré illustration from Paradise Lost. Public Domain. Source: Wikipedia
We fear losing a lot more than we value winning. That’s why money-back guarantees are so effective in getting us to try something new, even though it’s usually a real hassle getting our money back. We don’t want to get stuck with something we don’t want, and that guarantee sounds pretty good.
Three centuries ago, a mathematician figured this out by looking at the lottery. He suggested that if a peasant found a lottery ticket with a 50% chance of winning 20 thousand ducats, he would probably be willing to sell it for 9 thousand ducats. The certainty of having smaller amount in his pocket would outweigh the potential for a much bigger win. This notion has been validated by numerous experiments. The value we put on winning and losing is asymmetric.
Source: Kahnemann & Tversky, “Choices, Values, Frames”
We call this asymmetric behavior “loss aversion.” We worry about potential losses in the market even though gains are much more typical. It’s why investors overpay for safety when they buy bonds. Right now, high quality corporate bonds are priced as if they have a 7% chance of default. That’s about twice their historic average.
This gives rational investors an advantage. If people overpay for safety, we can take prudent risks and earn a little bit extra. By contrast, when everyone acts as if there’s no risk, that’s when things get overpriced. The market is a weighing machine, examining costs, benefits, risk, and uncertainty. It swings from fear to greed and back again.
And when everyone says they’re not afraid, that’s the time to get worried.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”