Sometimes, the hardest thing about investing in the stock market is the decision to get started. Many people already know that stocks outperform every other type of investment over the long term—GICs, bonds and real estate included. But how do you tell when it’s time to take the plunge? If share prices are falling, it’s tempting to want to postpone any investment until the market bottoms out. Conversely, high stock valuations—as in today’s market— inevitably arouse fears of a possible correction. Who wants to invest in something today that may be worth less six months down the road?
Faced with those uncertainties, many people opt to remain on the sidelines, even though doing so means missing out on a potential gain. In effect, these people judge the risk of losing money in the market to be more significant than the prospect of reaping a profit should stocks rise.
Psychologists have a name for that sort of behavior. It’s called loss aversion, and it’s an example of one of the most common errors in judgment that people can make when assessing investment opportunities.
To understand why, it’s worth delving into an area of research known as behavioral finance. The psychologist most closely associated with this field was Amos Tversky, an Israeli-born professor of behavioral sciences who died in Stanford, Calif., last year at age 59.
In 1979, Tversky and his longtime collaborator, Daniel Kahneman of Princeton University, published a groundbreaking paper that examined how people make decisions involving risk. Up to that point, most research into the behavior of financial markets had been based on the assumption that individuals were rational and tended to act in their own economic interest (the “efficient market theory”). Tversky and Kahneman, however, found that investors often ignore logic in decision-making and generally put more emphasis on risk than benefits.
The two researchers called this idea
Prospect Theory. In one of their most famous experiments, they gave a group of subjects the following scenario: suppose you have been given $1,000 and must choose between a sure gain of another $500 or, alternatively, a 50-per-cent chance to gain $1,000 and a 50-per-cent chance to gain nothing. Another group of subjects was presented with a different scenario: you are given $2,000 and must choose between a sure loss of $500 or, alternatively, a 50 per cent chance to lose $1,000 and a 50 per cent chance to lose nothing.
Tversky and Kahneman found that most members of the first group chose the sure gain of $500. A majority of the second group, however, opted for the gamble between a loss of $1,000 and a loss of nothing. In fact, both situations are identical in terms of the net financial benefit to the subject. The phrasing of the questions— the fact that one is presented in terms of gain and the other in terms of loss—is what causes them to be interpreted differently.
To the researchers, the lesson was that people are willing to run greater risks to avoid losses than they are to make gains. How does that influence the way people make investment decisions? Consider the person who prefers the certainty of a threeper-cent return on a GIC rather than the possibility of a greater gain by buying shares. In his determination to avoid risk, he chooses the option that will almost certainly yield a lower long-term return.
Another example of irrational behavior involves an investor who buys a stock at $10. Assuming that a year later it is still at $10 and appears unlikely to rise, most people would sell. But if the stock drops to $9, most investors will stubbornly hang in, risking further losses in the hope that the stock will return to its former level and they can get out whole.
As Tversky saw it, people will go to great lengths to avoid the sorrow and regret that comes with making a bad investment. The irony is that by doing so, they forgo opportunities for greater gain.
All too often, investors’ decisions are influenced by emotion rather than logic
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