Get the Bear, or the Bear Gets You
Good to Know
Loss aversion, taken to its extreme, can wreck long-term retirement planning and investment success. We’ll unpack what drives “irrational” loss aversion, identify a dangerous decision error, and illustrate a potential guardrail to remain on track with our long-term investing plans.
“Irrational” Loss Aversion
We’re a logical, evolved species, right? Before you answer, consider that your conscious brain is built upon a primitive set of instincts that have changed little in the last 50,000 years. You are alive to read this article because those ancient instincts (primal brain) led to the survival of our species.
Here’s the headline — your primal brain is alive, you may not be consciously aware of it, and it wields emotional power beyond belief. The primal brain was and is designed to do two primary things, both critical to human survival:
- Hunting and gathering and
- Detecting and avoiding danger.
| “The human brain is a superb machine – ‘a Maserati,’ says Baylor College of Medicine Neuroscientist Read Montague – when it comes to solving ancient problems like recognizing short-term trends or generating emotional responses with lightning speed. But it’s not so good at discerning long-term patterns or focusing on many factors at once – challenges that our early ancestors rarely faced but that we investors confront every day.”
Except from Are You Wired for Wealth? |
As we use our brains for far more complex tasks, including investing, these two primary functions of our brain can lead to investing decision errors.
For example, a “logical” investor under modern portfolio theory is assumed to seek gains with the same intensity as they fear losses. Regrettably, that notion of logic can be swept away by our primal aversion to loss. Several studies reinforce that conclusion. For example, would you bet $100 to gain $200? Assuming that each result is equally likely, the overwhelming majority of survey participants would not take that bet!
We can conclude that, at times, what is “logical” to our conscious mind is not at all logical to our primal brain.
Dangerous Decision Error — Panic Selling
Bull markets, bear markets, recessions, and expansions are all part of the normal economic cycle. For example, stocks plunged by over 30% during a one-month period during the Covid Crash. Investors who panic-sold near the bottom and went to cash missed out on a meteoric recovery less than three months later. The insidious compulsion of loss aversion is manifest not only in panic selling, but delaying re-entry into the stock market because cash is “safe.” The admonition that “you have to be present to win” applies emphatically to the stock market.
Yet, why do intelligent investors sell in a panic? Panic selling is not just logical; it’s imperative to our survival instincts. The visceral fear that losses will continue and the investor will be left with nothing is driven by an adrenalin-fueled “fight or flight” response. This response can overwhelm our rational, conscious brain and drive us to sell, sell, sell without thought for the long-term consequences. Why? Studies have shown that modern-day humans fear stock market losses in the same area of the brain as our ancestors felt the fear of being eaten alive by predators. Yet, the author has it on good authority that the number of attacks from saber-toothed tigers has been zero for about ten thousand years.
The risk of being eaten alive is all but gone today, but the primal fear is not.
Guardrail
One of the best defenses against panic selling is an experienced, savvy financial advisor. They can help clients see market fluctuations from a longer-term perspective. These perspectives can help clients address their unconscious primal fears and avoid decision errors such as panic selling and sitting on cash until the market approaches new peaks. In some cases, a market sell-off might even present buying opportunities as good stocks go “on sale.”
Next Steps
Click our CFP® Curriculum to dig deeper into the psychology of financial planning.
