The Biased Investor (Part 3)
No one likes to lose.
Public Domain. Source: Wikipedia
We’re a culture that thrives on winning. We don’t even like to think about losing. This holds true in sports, in relationships, and in finance. When a choice is presented between winning and losing, we fear the loss about twice as much as we value a gain. It’s one reason why money-back guarantees are so effective in marketing, even though they are rarely exercised. People don’t want to get stuck.
Three centuries ago the mathematician Daniel Bernoulli outlined our asymmetric view of risk. He suggested that if a poor fellow found a lottery ticket with a 50% chance of winning 20 thousand ducats, he would probably be willing to sell it for 9 thousand. The certainty of the lower sum would be more attractive than the potential for a higher amount. This notion has been validated by numerous experiments. The value we place on losses and gains is convex.
Source: Kahneman & Tversky, “Choices, Values, and Frames.” (1983)
Loss aversion is the term we use to describe this asymmetry. It’s why people worry about potential losses in the stock market rather than its much more common gains. It’s why investors overpay for security in the bond market. Right now, high quality corporate bonds are priced as if they have a 15% chance of default over the next ten years. That’s about ten times their historic default rate.
This gives rational investors an advantage. If other folks 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 the time to worry. We have nothing to fear but a lack of fear in the market.
Douglas R. Tengdin, CFA
Chief Investment Officer