Psychologists Daniel Kahneman and Amos Tversky won the Nobel prize in economics for developing a theoretical framework to show how we make often irrational decisions when faced with real life economic trade-offs. As a part of their prospect theory research, they showed that we are naturally loss averse; this means we experience more negative feelings associated with a loss, than we do positive feelings for a comparable gain. For instance, we feel worse about losing $100, than we feel happy for winning $100. Yet despite the recognition that this research has received, are we ignoring it in the financial planning world? Simply put: If our clients feel worse about a loss than they feel good about a comparable gain, shouldn't we be more proactive about protecting them from losses, even at the risk of giving up more gains?
The inspiration for today's blog post comes from a recent post at the Squared Away blog hosted by the Financial Security Project at Boston College, which discussed upcoming research about "How Emotions Drive Investing". I'll be writing further about the results of this new research itself at a later date; but the blog did start me thinking about some of the basic principles we've learned already from behavioral finance research, including our tendency for loss aversion.
As mentioned earlier, loss aversion represents our tendency to experience more negative feelings for a loss than we feel positive feelings for a comparable gain; it feels worse to lose $100 than it feels good to make $100. Accordingly, we essentially need to have an expectation up front that our gains will exceed our losses by some sufficient amount, before we're willing to take an uncertain risk.
Yet when I look at our standard advice as financial planners to clients who are afraid in risky situations - stay invested and stay the course - I can't help but wonder if we're ignoring natural investing and human tendencies to our own detriment. If clients experience more negative feelings about a loss than positive feelings about a gain, that conversely implies that they would experience more regret about failing to avoid a loss than they would about accidentally avoiding a gain. In other words, it implies that the client who is worried about markets and gets out before anything happens would be excessively happy about avoiding a subsequent disaster, to a greater extent than the client would be unhappy if the market turned out to go up.
This in turn feeds into another topic I have written about recently, "Why Is It ALWAYS Bad To Get Out Of The Markets In Times Of Risk?" As I discussed in that blog post, I find that we often confuse the impact of getting out of the markets AFTER a crash, from getting out of the markets BEFORE any crash has happened, because we fear it might be coming. The standard financial planning response is "yeah, but what if the markets go up?" Yet the research on loss aversion implies a clear answer: "Even if the markets do go up, our clients would regret it more if they stayed in and the markets went down!"
I wonder if part of the reason clients are so hard to manage is actually because we reinforce this negative cycle. Clients feel worried in times of economic distress and fear something bad will happen; we tell them not to worry and to stay invested; the bad thing happens, reinforcing that the client is right and the planner was wrong, in the midst of a stressful emotional environment; and even if the planner is later "proven right" because the market recovers, it doesn't help! If we experience more stress for a loss than we do joy for a comparable gain, then that means a portfolio that goes from $100,000 to $90,000 and back to $100,000 may be even, but emotionally our clients psychologically lost more sleep in the $10,000 decline than they gained in relief with the $10,000 recovery gain! In turn, this means that ongoing gyrations in the market steadily erode client comfort levels and contribute to rising stress, even if the portfolio is treading water and recovering its losses.
What would the alternative look like? Imagine a world where we celebrated the disasters our clients avoided, the goals we secured, and only secondarily acknowledged how we helped them get more, more, and more return? Even if we didn't maximize the client's return, removing severe downturns from the equation can help them live a happier life, reach goals in a more stable manner with less uncertainty. And who knows, maybe if we pay more attention to avoiding economic catastrophes, we might even mellow the extent of the bubbles that form in the first place. To say the least, though, at least we can create a world where our clients' biggest regrets are associated with the extra wealth they didn't make, rather than the real wealth they actually lost. Would that really be so bad?
So what do you think? Are we underestimating the emotional impact that loss aversion implies? Should we really be helping clients avoid losses more proactive, because the regret of not avoiding the loss may be greater than the regret of getting out and accidentally missing a gain?