In our experience, nobody likes losing – but just how powerful is the desire to avoid the feeling? Late psychologists Daniel Kahneman and Amos Tversky explored this question in 1979, and their Nobel-prizewinning research found that humans feel the pain of loss far more than the satisfaction of winning. They called this phenomenon myopic loss aversion or prospect theory, and we see it cited commonly in behavioural finance and psychology research today.[i] For good reason, too: understanding this concept is vital for investors, in Fisher Investments UK’s review, as it helps explain why people make emotional portfolio decisions – a key step in avoiding them.
Kahneman and Tversky’s landmark study, “Prospect Theory: an Analysis of Decision Under Risk,” analysed human behaviour during games (or prospects) involving bets, gambles and lotteries.[ii] In one case, the researchers asked Israeli participants to choose between:
- A) a 100% chance of losing $3,000 or
- B) an 80% chance of losing $4,000 and a 20% chance of losing nothing.
Then choose between:
- A) a 100% chance of receiving $3,000 or
- B) an 80% chance of receiving $4,000 and a 20% chance of receiving nothing.
Kahneman and Tversky conducted this study at a time when the average Israeli yearly wage was the equivalent of $3,000, so participants viewed the potential win or loss as an entire year’s pay – or more.[iii]
In the first scenario, 92% of respondents chose option B – a small chance at losing nothing despite a much higher probability of losing a greater sum instead of option A’s certain loss. In scenario two, most participants preferred the guaranteed $3,000 gain over the relatively small risk of winning nothing – even though a $4,000 prize was the more probable outcome. In Fisher Investments UK’s review, the results had a couple of key takeaways: one, people weighed a $3,000 gain differently than a $3,000 loss, even though the stakes were equal and the sums in question could materially impact one’s financial situation. Two, participants loathed losses so much that they were willing to risk losing more money for the low chance of avoiding loss altogether.
We think these findings have real implications for investors. Fisher Investments UK’s reviews of investor behaviour have found some people opt to exit the market amidst negative volatility – much like the study’s participants, the desire to avoid the pain of further losses is the primary focus. Whilst doing so might bring near-term feelings of relief or comfort, selling after equities fall locks in losses and risks missing their rebound. Our research has shown that, over time, missing out on these positive stretches can pile up and weigh on investors’ long-term returns.
For a recent example, go back to 2023, when global equities fell -6.2% from mid-September through late October 2023.[iv] Fisher Investments UK’s review of financial headlines at that time found concerns surrounding rising government debt yields and geopolitical conflict in the Middle East weighed on investors.[v] Those worries may have prompted some investors to exit equities as they sought some short-term relief from the possibility of markets falling further.
But this decision could have proven costly, in Fisher Investments UK’s review, since equities bounced back quickly, rising 10.8% from that October low through 2023’s end and 21.7% through 31 March 2024.[vi] Those missed returns – known as opportunity cost – along with the potential associated taxes and transaction fees, can hinder those who need equity-like growth to fund their long-term investing goals.
In our view, understanding myopic loss aversion can help reduce the likelihood of committing emotion-driven errors. Rather than reacting to past market returns, we counsel taking a forward-looking, long-term view. We think investors benefit from keeping their specific goals – and the returns that may be necessary to meet them – front of mind at all times.
This can require mental effort and self-awareness, but Fisher Investments UK’s reviews of investor behaviour show asking some basic questions before making portfolio decisions can help. First, self-reflect: why am I doing this? Is this an emotional decision or does it fit into my long-term investing plan? Then, look ahead: what if I am wrong? What are the potential consequences if the future pans out differently? Taking the time to ask these questions might help filter out the impulse to react emotionally.
To be clear, we aren’t advocating for investors to simply buy equities and refrain from touching their portfolio in perpetuity. In Fisher Investments UK’s experience, there are times when it makes sense to sell (e.g., if the reason for owning a given equity has changed). However, short-term volatility isn’t one of those reasons, in our view. Also note, despite plenty of negative spells and stretches, global equities’ long-term average annualised return is 10.0%.[vii] The price for earning that return, in our view, is staying disciplined through the market’s dips and bounces. Fisher Investments UK’s reviews of market history show participating in them doesn’t prevent investors from reaping equities’ long-term returns – vital in reaching one’s financial goals and objectives.
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This document constitutes the general views of Fisher Investments UK and should not be regarded as personalised investment or tax advice or a reflection of client performance. No assurances are made that Fisher Investments UK will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. Nothing herein is intended to be a recommendation or forecast of market conditions. Rather, it is intended to illustrate a point. Current and future markets may differ significantly from those illustrated here. In addition, no assurances are made regarding the accuracy of any assumptions made in any illustrations herein. Fisher Investments Europe Limited, trading as Fisher Investments UK, is authorised and regulated by the UK Financial Conduct Authority (FCA Number 191609) and is registered in England (Company Number 3850593). Fisher Investments Europe Limited has its registered office at: Level 18, One Canada Square, Canary Wharf, London, E14 5AX, United Kingdom. Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission.Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission. Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.
[i] “Prospect Theory: An Analysis of Decision Under Risk,” Daniel Kahneman and Amos Tversky, Econometrica, 47(2): 263-291. March 1979.
[ii] Ibid.
[iii] Ibid.
[iv] Source: FactSet, as of 7/5/2024. Statement based on MSCI World Index return with net dividends in pounds, 14/9/2023 – 31/3/2024.
[v] Source: FactSet, as of 7/5/2024. Statement based on US 10-year Treasury and UK 10-year Gilt yields, 31/8/2023 – 18/10/2023.
[vi] See Note iv.
[vii] Source: FactSet, as of 7/5/2024. Statement based on MSCI World Index annualised return with net dividends in pounds, 31/12/1970 – 31/12/2023. Citing in British pounds due to the euro’s limited history. Currency fluctuations between the euro and pound may result in higher or lower investment returns. An annualised return is the compound annual growth rate that would deliver the cumulative return over a given period.