When it comes to investing, what keeps you up at night? Is it the fear of the unknown or the fear of losses or both?
I think it was Donald Rumsfeld, the former US defence secretary, who summed it up best about the unknowns: "There are known knowns; these are things we know we know. There are known unknowns; that is to say, there are things that we know we don't know. But there are also unknown unknowns; there are things we don't know we don't know."
Confused? Don't be. Our fears can be scientifically explained. Did you know that investors experience the pain of losses two and a half times more strongly than they experience the joy of gains?
Scientists have discovered that the frontal lobe of the brain _ the part that puts together and understands data _ processes and analyses most of the information related to gains.
But it is the limbic system _ the more primitive part _ that has to do with the emotional aspect of the brain that comes into play when processing losses.
It's a behavioural concept called "loss aversion". In a nutshell, it can cause rational people who find themselves preoccupied with the fear of sustaining losses to make costly investment mistakes.
Loss aversion can manifest itself among investors in a number of ways. Being too conservative with long-term capital is a classic example. Far too many provident funds including the Government Pension Fund do not invest enough in historically higher-performing asset classes such as stocks and commodities even though they are in a position to do so because their investment mandate is geared towards the long term.
This lack of understanding, often by the members of the funds rather than the fund managers themselves, often leads to an overly conservative portfolio comprising 75% bonds and 25% stocks.
Maintaining a long-term investment strategy that is too conservative can result in returns that fail to outpace inflation and cause a shortage of income necessary to sustain a desired retirement. During periods of high market volatility, loss aversion can cause investors to make sudden and rash short-term decisions that may alter a smartly constructed investment strategy.
In times of stress, many investors suffer from what is called "willpower depletion" or "decision fatigue".
We all have a finite store of mental energy for exerting self-control. Sticking with the long-term financial plan requires energy. When we are mentally depleted, we lose the willpower and become open to making trade-offs, doing something impulsive or letting go of the long-term plan. Whatever looks easy becomes attractive.
Behavioural finance also teaches us that as investors we tend to focus more on information that confirms our viewpoint and discount information that counters our opinion.
One cure is to keep an open mind and read a broad spectrum of market commentary including material that challenges your current thinking. Listed below are some of the key takeaways that can help you to overcome your hidden fears and loss aversion:
- Short-term volatility is the norm _ not the exception _ in the history of the stock market, and the long-term trajectory of stock prices has been upward.
- Investors with long-term horizons such as provident funds, RMFs and LTFs should recognise that being too conservative with asset allocation could put investment objectives at risk.
- Historically, investors have increased their cash position during bear markets but been slow to reallocate to stocks. Sudden corrections and sudden rallies have been a normal part of the stock market over time, and attempting to move in and out can be a costly endeavour.
- The bottom line: stay invested.
Teera Phutrakul is chairman of the Thai Financial Planners Association.
About the author
Writer: Teera Phutrakul