What Do Sabre-Toothed Tigers and Investments Losses Have in Common?
Good to Know
We introduced the concept of Behavioral Finance in the author’s most recent blog. Specifically, we learned that financial decisions that are rational to our subconscious, primal survival instincts can be breathtakingly irrational to our conscious, objective brains. One of the most perplexing and frustrating examples of this phenomenon is buying high and selling low. Behavioral scientists primarily explain this vicious, all-to-common cycle by two powerful survival instincts (psychological influences) inherited from early man: Herd Mentality Bias and Loss Aversion Bias.
Herd Mentality Bias—To Eat or Be Eaten?
You are alive to read this information in part because of this influence. Early man formed groups (herds) for survival purposes such as to:
- Defend against being eaten alive by predators like the saber-toothed tiger and
- Hunt dangerous prey like woolly mammoths.
Here’s the short version—being caught outside of the herd may have meant becoming the tiger’s entrée.
But, unfortunately, that very same mentality can trigger us to “herd” with other investors when we should not. For example, we may feel subconsciously driven to buy that “hot stock” that everyone else is buying, even if a more considered analysis could reveal that the stock’s growth has flattened or peaked. Likewise, investors who buy near the top of the market may be reacting instinctively to an overpowering, primal need for the “safety” of the herd.
Loss Aversion Bias Primal Fear of Loss
Loss aversion can manifest in our selling too low because we fear losing even more if the investment continues to fall in value. This bias is ingrained in our instincts courtesy of our ancient ancestors; they lived an “on the edge” existence where the loss of a resource, food stores, for example, could mean starvation for an entire family. Keep that bias in mind as we consider Modern Portfolio Theory (MPT) for a moment. MPT assumes a rational investor, defined for these purposes as an investor who seeks gain equally as much as they seek to avoid loss. While there is much to commend MPT, investors are not always rational by this measure.
Experiments1 have shown that the emotional pain we feel when losing something we own is greater than the emotional joy at an equivalent gain. Answer the following question as an example.
Imagine a coin toss. Heads you win, tails you lose. What minimum potential gain would induce an average person to take a coin-toss bet in which they could lose $10? 1
- $15.00
- $17.50
- $20.00
- $22.50
- $25.00
The answer is shown below.2
Summary
Each one of us has instinctive reactions to danger. When that danger is the threat of a car hitting a child that’s wandered into the street, our lightning-fast, instinctive reaction is to snatch the child from danger. After saving the child, we may have no recollection of conscious thought—we simply reacted. Had we paused to think about the threat, form a plan of action, and then act, it may have been too late to save the child. It’s only when the danger is not life-threatening that our instincts can betray us into financial decision errors. As financial planners and advisors, our role is to help clients take a breath, pause, engage their conscious brain, and put a market drop or popular stock into a long-term investment perspective.
1 Tversky, A. & Kahneman, D. (1992). “Advances in prospect theory: Cumulative representation of uncertainty.” Journal of Risk and Uncertainty 5(4): 297–323.
2 According to Tversky and Kahneman, the potential win must be at least $22.50.
Disclaimer
The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide tax, legal, compliance or financial advice. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this blog.
