Loss Aversion and Your Retirement Portfolio
By: Alan Heyman, Wealth Adviser, Sasfin Wealth
Nobel Prize-winning Psychologist Daniel Kahneman, noted behavioral economist and researcher, revealed that in evaluating people’s behaviour, the pain they feel for their loss is twice as strong opposed to an equivalent gain. The emotions felt for a loss last far longer, resulting in a behavioral bias known as loss aversion.
The desire to avoid loss in making long-term decisions could have negative impacts, including:
Given the current market volatility, if a loss does occur, negative short-term events should not give rise to an urgency to act to ‘fix’ the problem to reduce future losses. A poor decision in a long-term investment strategy may impact your retirement capital significantly over your life time. Avoid making changes to your portfolio just because you have an urge to change something.
Fear of loss
It is human nature to dislike and avoid uncertainty, even though our future is inherently uncertain. That’s because uncertainty when dealing with money brings on anxiety to most people.
According to the 2016 Market Sentiment Report:
Assessing risk tolerance (the willingness and the capacity for taking risk) is a key component needed when understanding how people react to loss when making investment decisions. However, if you understand when taking prudent risk can help you meet your long-term objectives, you may be willing to accept risk you would otherwise reject; because your understand volatility is in your best interest.
Every change calls for a conscious and well-founded decisions to be made. Taking a long-term approach to your overall situation, should be the foundation on which you based your portfolio decision. Both personal and professional changes can affect your income and financial situation. An analysis of your current situation and an assessment of future scenario will form the basis for future decision planning.
If one particular investment in a spread of diversified investments performs poorly then you still have others to fall back on. For instance, when company shares are doing well, fixed income often under performs. Similarly, when share prices are falling, fixed income frequently rises in value. Holding them together in a portfolio means you enjoy smoother investment returns over the long-term. Any sharp rise or fall in value of one can be offset by the performance of the other.
Each of the various asset classes carry different risk and offer higher or lower potential rewards. History has shown that shares typically provide the best return over the long term. However as you are aware, shares can be volatile over the short term and can fall in value. Fixed income meanwhile, does not offer the same long-term growth potential as some other asset classes, but tends to be less volatile than shares.
Generally speaking, the asset class that offers the highest potential rewards carry the highest potential risk. Establishing the correct mix of investments for your personal situation is very important. You need to be comfortable that the balance between risk and rewards is right for your particular circumstances. If your attitude to risk and capacity for loss changes, you will need to realign your portfolio accordingly.
Hunting for stability
Loss aversion for most people, gets factored into their investment decision only after they retire. People with a higher risk tolerance took the responsibility to plan and manage their investment portfolio long before their retirement. These investors understand how taking calculated risks help them meet their long-term plans. Allowing them to more freely accept risks which others would normally reject, not because they are comfortable with loss but because they know and understand how to deal with the discomfort caused by volatility and the long-term benefit the right strategy delivers.
The opposite is true of those new to managing their investments. They often underestimate their discomfort to loss, causing them to sell when they experience market movements. Loss aversion may cause investors to misunderstand the impact of long-term low returns have on their portfolios ability to provide inflation linked income throughout their retirement years.
Growth targeting assets, such as shares/equities generally form a critical component to any long-term wealth creating retirement portfolio. Chasing the comfort for safety, specifically to avoid loss is compounded by investor’s frequent review of their portfolios in times of volatility. Equities over time have been a rising one, albeit there are many declines along the way. If you frequently check your portfolio returns, you are going to feel every bump and suffer from heighten uncertainty and perhaps even anxiety.
Loss aversion is in our DNA as its ability to impact your investment choices. Rather than fighting against this, consider getting professional investment advice.