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Percentages Going Up, Dollars Going Down

Posted by Michael Kitces on Tuesday, November 16th, 6:36 pm, 2010 in Investments

Most planners doing financial planning reviews with clients have witnessed the phenomenon: when markets go up, clients look at their growth rates; when markets go down, clients look at the dollars they have lost. What can behavioral finance tell us about why we have such an asymmetric view of the market's ups and downs?

Behavioral Economics - Loss Aversion

The growing field of behavioral economics has shown that as human beings, we are actually wired to experience losses different than we experience gains: the phenomenon is called "loss aversion" in research parlance. Although the research mathematics of loss aversion are complex (can you say "curvilinear utility graph"?), the basic principle is relatively straightforward: we experience more distress when there is a loss than we experience in joy when there is an equivalent gain.

This manifests in numerous ways in the markets and client behavior. First, most planners have witnessed the fact first-hand that clients do in fact tend to be far more distressed about a certain amount of loss than they are about a comparable gain. Second, the nature of bull and bear markets themselves reflects our loss aversion tendencies; bull markets often take years to manifest and become self-reinforcing, while bear markets often take shape in days, weeks, or maybe months. We react more strongly to the losses and exhibit behavior responses (e.g., sell) more quickly than with the gains.

I believe that our tendency towards loss aversion also helps to explain why it is that we tend to want to characterize gains in percentages but losses in absolute dollars. In essence, as our loss aversion triggers emotions of fear and negative feelings about the loss itself, our brains immediately revert to the question "what will it take to recover our loss." In this context, our brains anchor to how we generated the investment assets in the first place: saving from income. A 10% loss on a $500,000 portfolio isn't a 10% loss that requires an 11.1% return to recover; it's 7 years of saving over $7,000/year from our income - and 7 years of recovery can be a pretty distressing proposition.

Conversely, because we do not have such a visceral, emotional response to our gains, we can have what is arguably the more "rational" response - to evaluate the percentage growth of our returns, on an absolute basis and relative to investment alternatives. Accordingly, we can then judge whether our return was a "good" return - and good relative to what - in a rational and logical manner. Growth is about what our assets did; losses are about what we need to do (i.e., save) to make it up; accordingly, growth is about percentage returns, while losses are about dollars (of savings).

Bear Markets And The Portfolio Size Effect

Notably, this is also indirectly why clients become increasingly distressed by bear markets as their portfolios grow. The rational client would realize that it takes the same investment returns to recover from a 10% decline, regardless of whether the portfolio is $10,000, or $100,000, or $1,000,000. However, the emotional loss averse client who is anchoring to actual dollar losses based on the portfolio size, and imagining how it can be recovered - by additional savings from income - feels exponentially increasing stress. Making up $1,000 from cash flow on a 10% decline in a $10,000 portfolio is one thing; "re-"saving $100,000 to recover a 10% loss from a $1,000,000 portfolio is far more concerning, even though both require the same pure-investment-return to break even.

So the next time you witness your clients exhibiting distress about losses in dollar terms, realize that often it's because they're thinking about it in context not of what portfolio investment return it will take to recover, but what saving they will have to do to make up the loss - the emotional response that is natural for our loss-aversion-oriented psyche that is anchored in cash flow. In reality, many clients actually can and will recover their losses via future investment returns - which means they may need to defer retirement and have a longer time horizon to help make up the losses, but may not necessarily need to save more (unless they're focused on retiring at a specific date and are unwilling to modify their retirement spending goals).

Nonetheless, if you want to have a conversation with the client about this emotional issue, remember that clients cannot move away from an emotional state of mind until it has been acknowledged and dealt with. In the meantime, realize that they may not be thinking just about the losses in the portfolio and the returns involved to recover. Your clients may have anchored their evaluation elsewhere, such as the amount of savings it will take to make up the loss, and the larger the portfolio, the more daunting that can be.

So what do you think? Have you witnessed this kind of behavior in your own clients? Do you find that your clients measure their losses using a yardstick like their dollar amounts of savings, rather than the required future return on their portfolio?


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Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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