Investors are loss averse, meaning they put more weight on losses than gains when they consider risky prospects, said Daniel Kahneman, Princeton University professor, at the IMCA 2015 New York Consultants Conference. So how much are investors willing to lose? In general, they’re willing to shell out $100 for every $250 or more that they can gain.
“We call that the loss aversion coefficient, and that’s the extent to which people are more sensitive to losses than to gains,” Kahneman said to a room full of advisors at the Sheraton in New York.
Under standard financial analysis, people should be more concerned with their wealth, not thinking in terms of losing their wealth. This tends to distort the decision-making process.
People are also prone to the hindsight phenomenon, Kahneman said, in that the event that looked uncertain before it happened seems obvious after the fact. Take the most recent Super Bowl, between the New England Patriots and the Seattle Seahawks. We view the whole game in light of what happened in the end, when the Seahawks decided to pass the ball instead of running it, and the Patriots intercepted it. This is hindsight.
The hindsight phenomenon can have terrible implications for financial decision-making. “It induces us to believe the world is a place we understand,” Kahneman said. Even when we can’t guess the future, we feel we should.
Hindsight also causes regret; once you’ve made a choice and it turns out badly, you blame yourself and your financial advisor. People feel the pain of regret acutely, and act on it. But acting on it can be disastrous. Take retail investors, for example, who often buy high and sell low. Stocks that people sell do better than those people buy by 3.5 percent on average, Kahneman said.
Investors sell when things are going bad because they regret they lost that money. There’s also a sense of regret in buying, in that you regret having missed out on the success. Financial advisors need to try to prevent people from making that kind of mistake, Kahneman said.
If you offer people a gift of $10,000 or a more risky bet with a great potential payoff, they will almost always take the cash. But there are bets that people like better than cash: a 90 percent chance to win $9,000; and a 10 percent chance to win $19,000. People tend to be comfortable with the combination of a sure thing and a long shot, and portfolios should be constructed with this in mind, Kahneman said.
“People think small,” Kahneman said, and this can also lead them to be more risk averse. If you give people feedback after every gamble, they will be more risk averse. But if you give feedback after several gambles, they will be less risk averse because results fluctuate less when you give feedback occasionally. They will encounter failure less often, and will want to change their minds less often.
Kahneman’s advice? “Don’t churn, and don’t trust your own confidence.” If you, as an advisor, have ideas about what’s going to happen, the reason you’re confident is that in the past world, it seemed to make sense. But you can’t predict the future. We live in a world where experience is possible, but expertise about the future is not possible. If you feel you have expertise in picking stocks, you should be enormously rich. If you’re not, then you’re wrong.
“Adopt a policy and stick to it,” Kahneman said.
Also, ask clients, “How much are you willing to lose before you change your mind and bail out?” If they want to bail out after only a moderate dip, they probably shouldn’t be investing in it in the first place.