The age-old theory
that fear of losing money drives financial decisions is under fire
Loss aversion is a central idea in behavioural finance. Two
academics have challenged it and kicked up a storm between hedge-fund managers
and finance professionals.
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Avanti Feeds is one of the favourite stocks in the mid-cap
segment. It has given extremely high returns to its investors: 350% over the
last three years.
The dream run ended in the beginning of June, when the stock lost 38% in 10 days. (It also recovered rapidly: 38% in two days.)
The fall hit loyal investors hard. “Those who purchased this stock four years ago and saw multiple growth will now be pained ten times more,” says a fund manager.
He is hinting at the phenomenon of loss aversion.
Most investors like stocks that give lower but relatively certain returns. They are willing to pay a premium for such stocks. But a high-growth stock with relatively high uncertainty of performance is something that investors with serious loss-aversion bias tend to avoid.
Or do they?
Challenging a core belief of behavioural economics
Since January, the mid-cap index has fallen 13%. It was up 140% over the last four years. Conventional wisdom would suggest that for mid-cap investors with loss aversion, the pain of the last eight months would have overriden the pleasure from the gain. In general, the theory of loss aversion states that losses cause twice the pain compared with the pleasure of gains.
Now two finance professors are challenging this theory, which is one of the key pillars of behavioural economics. They say there is little evidence that investors focus more on the possibility of loss rather than expectation of gain while making decisions.
In a recent review published in the Journal of Consumer Psychology, David Gal and Derek Rucker say loss aversion is a fallacy. According to them, people do not rate the pain of losing USD10 to be more intense than the pleasure of gaining USD10.
Gal is a professor of marketing at the University of Illinois, and Rucker teaches marketing at Northwestern University.
Essentially, what the two professors have done is challenge the prospect theory, which was developed by Daniel Kahneman and Amos Tversky, two psychologists who created the field of behaviorial economics. The prospect theory posits that people make decisions based on the probabilistic value of losses and gains rather than the final outcome.
“What is most fascinating to me about the premise that Gal and ... Rucker … have pushed forward is around the meta-concept that challenging the status quo is an uphill battle. They are on to something here, though surely they recognize that Daniel Kahneman and Amos Tversky’s famous theory was itself not accepted for a long time. Kahneman and Tversky’s ground-breaking 1979 paper was an assault on the status quo at the time, and it took decades before their thesis was assimilated into psychology and economics”, says Barry Ritzoltz, co-founder and CIO of Ritzoltz Wealth Management LLC in a Bloomberg article.What does it say? Pain of losing is twice as powerful as the pleasure of gaining.
A real-life example: Economist Paul Samuelson asked a colleague whether he would be willing to accept the following bet: a 50% chance to win USD200 and a 50% chance to lose USD100.
The dream run ended in the beginning of June, when the stock lost 38% in 10 days. (It also recovered rapidly: 38% in two days.)
The fall hit loyal investors hard. “Those who purchased this stock four years ago and saw multiple growth will now be pained ten times more,” says a fund manager.
He is hinting at the phenomenon of loss aversion.
Most investors like stocks that give lower but relatively certain returns. They are willing to pay a premium for such stocks. But a high-growth stock with relatively high uncertainty of performance is something that investors with serious loss-aversion bias tend to avoid.
Or do they?
Challenging a core belief of behavioural economics
Since January, the mid-cap index has fallen 13%. It was up 140% over the last four years. Conventional wisdom would suggest that for mid-cap investors with loss aversion, the pain of the last eight months would have overriden the pleasure from the gain. In general, the theory of loss aversion states that losses cause twice the pain compared with the pleasure of gains.
Now two finance professors are challenging this theory, which is one of the key pillars of behavioural economics. They say there is little evidence that investors focus more on the possibility of loss rather than expectation of gain while making decisions.
In a recent review published in the Journal of Consumer Psychology, David Gal and Derek Rucker say loss aversion is a fallacy. According to them, people do not rate the pain of losing USD10 to be more intense than the pleasure of gaining USD10.
Gal is a professor of marketing at the University of Illinois, and Rucker teaches marketing at Northwestern University.
Essentially, what the two professors have done is challenge the prospect theory, which was developed by Daniel Kahneman and Amos Tversky, two psychologists who created the field of behaviorial economics. The prospect theory posits that people make decisions based on the probabilistic value of losses and gains rather than the final outcome.
“What is most fascinating to me about the premise that Gal and ... Rucker … have pushed forward is around the meta-concept that challenging the status quo is an uphill battle. They are on to something here, though surely they recognize that Daniel Kahneman and Amos Tversky’s famous theory was itself not accepted for a long time. Kahneman and Tversky’s ground-breaking 1979 paper was an assault on the status quo at the time, and it took decades before their thesis was assimilated into psychology and economics”, says Barry Ritzoltz, co-founder and CIO of Ritzoltz Wealth Management LLC in a Bloomberg article.What does it say? Pain of losing is twice as powerful as the pleasure of gaining.
A real-life example: Economist Paul Samuelson asked a colleague whether he would be willing to accept the following bet: a 50% chance to win USD200 and a 50% chance to lose USD100.
§
The colleague turned down that bet, but announced that he was
happy to accept 100 such bets.
§
Here is what the colleague offered as his rationale for turning
down the bet: "I won’t bet because I would feel the USD100 loss more than
the USD200 gain.” A string of 100 bets, the colleague felt, would give a better
chance of gains.
Effect of loss
aversion
§
Researchers say it explains the equity premium puzzle,
which says stock returns sometimes appear to demonstrate a high degree of risk
aversion.
§
It gives rise to the disposition effect, in which investors
tend to sell off winners too early and hold on to losers for too long.
The challenge and the
response to it
Gal and Rucker argue that loss aversion as a concept took wings because contradictory evidence was dismissed, ignored, and explained away, while ambiguous supportive evidence was magnified.
According to them, the phenomenon of sunk-cost effect, where people keep repeating an activity or an idea that doesn’t give any returns, is attributed to loss aversion. This is wrong.
“While the sunk-cost effect might reflect a reluctance to recognise losses, this is not relevant to loss aversion, which requires [that] a comparison be made between losses and gains”, Gal wrote in Scientific American.
The article stirred much debate on Twitter, with some well-known investors sinking their teeth into the subject. Financial philosopher Nassim Nicholas Nassim Taleb tweeted that loss aversion is fiction, citing Gal and Rucker.
Drew Dickson, CIO and managing partner at Albert Bridge Capital, took an opposing position. Gal and Rucker say that risky choices, such as buying a lottery ticket, are gain-seeking behaviour. Dickson says: “They haven’t considered that the buyer doesn’t believe his payoffs are symmetric. If you think betting USD1 gives (what you – albeit mistakenly – believe to be) a reasonable chance of making USD1,000,000; you aren’t risk averse.”
He tweeted, “So, sure, a billionaire will not distinguish between a USD100 loss and a USD100 gain as much as Taleb’s at-risk baker with a child in college; but add a few zeros, and the billionaire will start caring,” and “Losses (that are significant to the one suffering the loss) feel much worse than similarly sized gains feel good. Just do the test on yourself”.
Cliff Asness, founding partner of hedge-fund giant AQR Funds, tweeted: “The new study doesn't make me doubt loss aversion very much. Though a different question is how much such biases affect prices/returns. Always have to separate those two things. Market efficiency doesn't rely on each individual being a Vulcan.”Bugbear of value investors
Yes. Market efficiency doesn’t rely on each individual being a Vulcan. It depends on the market’s collective smartness. Do the biases of individual investor affect prices and returns? That is the question that requires serious research.
Loss aversion will have an effect on prices or returns for some time. Ask value investors. Their first rule of investment is not to lose money. They work real hard to preserve capital. Ideally, they are ultra aware of loss aversion. But only the smart ones can turn this into an opportunity. They can spot a scenario where the prices of some stocks fall so much that the risk of falling further is nullified. These investors buy such stocks, whose intrinsic value is infinite. But such opportunities are few.
In most cases, value investors miss out on good opportunities due to loss aversion. They know their subject so well that they are not ready to take even calculated risks.
A case in point, as we earlier wrote, is that value investors will not invest in an Avenue Supermart or a Bandhan Bank because they will give a lot of importance to that one negative point that might cause pain to these companies in the near future. For them, these stocks need to fall massively from their issue price to eliminate loss aversion.
They are willing to let go of the possibility of manifold gains in these stocks because they know that the pain they will experience if they don’t perform will be extremely high.
Warren Buffett avoids investing in technology stocks precisely for this reason. He is worried about that one technology upstart that will come and wipe out the existing order. He did not invest in Amazon. The company did not pass through the filters of his value parameters. Today, Buffett says he regrets the decision. In a CNBC interview in May 2017, he said it was out of stupidity that he did not invest in Amazon.
Smart investors understand that investment is a psychological game, and while investment models can capture the intrinsic value of a stock, it is the emotional aspect of how much to buy and how long to hold the stock that is an art.
This is where loss aversion comes in. The most informed value investor will suffer more damage emotionally than the one who is taking relatively blind risks. And this is the problem that Gal and Rucker have not been able to address properly.
They have generalised all people into one basket. If investors are more invested into a particular topic, they will feel more pain if their idea doesn’t work. This is where the biases of sunk-cost fallacy gets explained through loss aversion.
So loss aversion does exist. Investors who have burnt their fingers in the dotcom bust are still scared to enter the stock markets. Those who purchased infrastructure stocks in 2007 are still licking their wounds. But truly seasoned investors are able to look beyond the pain of loss and continue investing.
Ask yourself this simple question: Do you concentrate too much on that one loss-making stock, or does the overall gain in your portfolio excite you more? If the odd bleeding investment wipes out the thrill of seeing your money grow, Gal and Rucker have work to do.
Gal and Rucker argue that loss aversion as a concept took wings because contradictory evidence was dismissed, ignored, and explained away, while ambiguous supportive evidence was magnified.
According to them, the phenomenon of sunk-cost effect, where people keep repeating an activity or an idea that doesn’t give any returns, is attributed to loss aversion. This is wrong.
“While the sunk-cost effect might reflect a reluctance to recognise losses, this is not relevant to loss aversion, which requires [that] a comparison be made between losses and gains”, Gal wrote in Scientific American.
The article stirred much debate on Twitter, with some well-known investors sinking their teeth into the subject. Financial philosopher Nassim Nicholas Nassim Taleb tweeted that loss aversion is fiction, citing Gal and Rucker.
Drew Dickson, CIO and managing partner at Albert Bridge Capital, took an opposing position. Gal and Rucker say that risky choices, such as buying a lottery ticket, are gain-seeking behaviour. Dickson says: “They haven’t considered that the buyer doesn’t believe his payoffs are symmetric. If you think betting USD1 gives (what you – albeit mistakenly – believe to be) a reasonable chance of making USD1,000,000; you aren’t risk averse.”
He tweeted, “So, sure, a billionaire will not distinguish between a USD100 loss and a USD100 gain as much as Taleb’s at-risk baker with a child in college; but add a few zeros, and the billionaire will start caring,” and “Losses (that are significant to the one suffering the loss) feel much worse than similarly sized gains feel good. Just do the test on yourself”.
Cliff Asness, founding partner of hedge-fund giant AQR Funds, tweeted: “The new study doesn't make me doubt loss aversion very much. Though a different question is how much such biases affect prices/returns. Always have to separate those two things. Market efficiency doesn't rely on each individual being a Vulcan.”Bugbear of value investors
Yes. Market efficiency doesn’t rely on each individual being a Vulcan. It depends on the market’s collective smartness. Do the biases of individual investor affect prices and returns? That is the question that requires serious research.
Loss aversion will have an effect on prices or returns for some time. Ask value investors. Their first rule of investment is not to lose money. They work real hard to preserve capital. Ideally, they are ultra aware of loss aversion. But only the smart ones can turn this into an opportunity. They can spot a scenario where the prices of some stocks fall so much that the risk of falling further is nullified. These investors buy such stocks, whose intrinsic value is infinite. But such opportunities are few.
In most cases, value investors miss out on good opportunities due to loss aversion. They know their subject so well that they are not ready to take even calculated risks.
A case in point, as we earlier wrote, is that value investors will not invest in an Avenue Supermart or a Bandhan Bank because they will give a lot of importance to that one negative point that might cause pain to these companies in the near future. For them, these stocks need to fall massively from their issue price to eliminate loss aversion.
They are willing to let go of the possibility of manifold gains in these stocks because they know that the pain they will experience if they don’t perform will be extremely high.
Warren Buffett avoids investing in technology stocks precisely for this reason. He is worried about that one technology upstart that will come and wipe out the existing order. He did not invest in Amazon. The company did not pass through the filters of his value parameters. Today, Buffett says he regrets the decision. In a CNBC interview in May 2017, he said it was out of stupidity that he did not invest in Amazon.
Smart investors understand that investment is a psychological game, and while investment models can capture the intrinsic value of a stock, it is the emotional aspect of how much to buy and how long to hold the stock that is an art.
This is where loss aversion comes in. The most informed value investor will suffer more damage emotionally than the one who is taking relatively blind risks. And this is the problem that Gal and Rucker have not been able to address properly.
They have generalised all people into one basket. If investors are more invested into a particular topic, they will feel more pain if their idea doesn’t work. This is where the biases of sunk-cost fallacy gets explained through loss aversion.
So loss aversion does exist. Investors who have burnt their fingers in the dotcom bust are still scared to enter the stock markets. Those who purchased infrastructure stocks in 2007 are still licking their wounds. But truly seasoned investors are able to look beyond the pain of loss and continue investing.
Ask yourself this simple question: Do you concentrate too much on that one loss-making stock, or does the overall gain in your portfolio excite you more? If the odd bleeding investment wipes out the thrill of seeing your money grow, Gal and Rucker have work to do.
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