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Your fear of loss may be costing you

January 27, 2013

Do you always make rationale decisions?  We may like to think so, but research shows otherwise.  In the past, economics usually assumed everyone would make rationale decisions on what gives people the most utility.  Economists Daniel Kahneman and Amos Tversky have shown this isn’t always the case.  In one of their famous research journals on prospect theory Kahneman and Tversky (1979) show that we aren’t always rationale.

First, in general we are loss averse.  Let’s say you had a 50-50 chance of getting $1,000 or a 100% chance of getting $500.  In the long run, these should be just about equal situations as your long term expected payoff in both examples is $500.  If you are like most though you probably chose the $500.  In the experiments by Kahneman and Tversky, 84% of those surveyed took the sure thing in the $500.

When looking at losses the results were the opposite.  If you had a sure $500 loss or a 50-50 chance of losing a $1,000 or losing nothing, 69% of people choose the 50-50 gamble on the loss as opposed to the sure $500 loss.

The general idea behind this is we are loss averse.  We generally take the sure thing even if it isn’t the best in the long run.  For example over the last 50 years the S&P 500 has had an average return of 9.8%.  It has a standard deviation of 15% meaning that 68% of the time in one year the S&P 500 will range from a loss of about 5% to a gain of 25%.  95% of the time the annual return will be between a loss of 20% and a gain of 40%.

It is easy to see in the long run your expected return in around 10% which is a good long term investment.  The problem is if the S&P 500 has a 10% loss one year, it scares many people.  In turn these people make their own choice, do they want to take a chance where they could gain a lot or have a small chance of losing money or do they want a sure thing with a much smaller return.

When the market decreased a great deal in the last five years many people said we don’t want to take that risk anymore and moved their money into investments with very small returns.  When looking at the rationale this doesn’t make sense, but because many people are loss averse they’ll trade the long term expected gains due to the fact they don’t have the chance to loss an money on an investment with a smaller return.

Be aware of your loss aversion and don’t let this harm your long term retirement or college savings.  If you are putting your retirement savings into savings accounts, money markets, or CDs and have over 10 years until you retire you probably won’t lose the money, but your expected return isn’t large enough for you to beat inflation.

Work Cited:

Kahneman, D. and A. Tversky.  (1979)  Prospect theory:  An analysis of decision under risk.  Econometrica  47(2), 263-292.

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