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How loss aversion can trip up investors
Behavioural scientists have long known that investors’ biggest obstacle to achieving success is likely to be themselves. Science has shown that people are predictably irrational, especially when it comes to making decisions under conditions of uncertainty, in other words, when making investment decisions.
In this article we explain one of the most powerful psychological factors that influences investors, loss aversion. We look at how pain from a past loss can create a mental block or bias which prevents investors from properly appraising new facts in an unbiased way.
Under the well-known efficient markets hypothesis stock prices are supposed to reflect all publicly available information while new information is quickly assimilated.
Over the last few decades scientists have discovered this neat description of investor behaviour has a few chinks.
PAIN TRUMPS PLEASURE
Let’s play a game where you must guess heads or tails in a coin toss, and it costs you £100 if you guess incorrectly. How much would you expect to be paid if you guessed correctly?
Logically you would demand at least £100 and possibly slightly more, assuming a fair toss, because the long-term odds are 50/50. Anything above £100 would provide you with a tidy profit over the long run.
The surprising thing is that when investment strategist at GMO James Montier asked more than 600 fund managers the same question, the average response was just over £200.
In other words, the managers needed to win twice as much to make the bet attractive. In general people hate losses somewhere between two and two and-a-half times as much as they enjoy gains. This is loss aversion in action.
Losses hurt more than gains, and this seems to be hard wired into our brains and dates back millions of years.
LEARNING FROM PAST MISTAKES
When Shares picked energy company Centrica (CNA) in December 2019 as a stock to buy for the year ahead, at the time we thought the shares had a good chance of performing well and a low chance of losing money.
We believed the deleveraging of the group via the sale of oil and gas production assets and the renewed ambition of the British Gas retail division to be the lowest cost provider in the market would reenergise the company’s fortunes.
However, the company was dogged throughout 2020 by operational issues as well as pandemic headwinds, and the shares lost around half their value.
While not the worst of our stock picks that year it did detract from the overall performance of our ‘stocks for 2020’ portfolio, but fortunately, we had some winners and ended up with an average gain of 4.8% in 2020 compared with an 8.7% loss for the FTSE All-Share.
In the Autumn of 2021, Centrica popped up on one of Shares’ earnings revisions screens, indicating it was receiving stronger than average earnings upgrades from analysts.
The news flow at the time suggested the company was well positioned to pick up stranded clients from the failure of rival energy providers impacted by the spike in natural gas prices.
Although it wasn’t clear how significant this might become, the shares appeared to be responding positively to the news.
Probably because we were unduly influenced by the pain of making a bad call on Centrica in the past, we couldn’t quite reach a positive decision on the stock and took a wait and see attitude.
Well-respected economist and investor John Maynard Keynes said: ‘When the facts change, I change my mind, what do you do, Sir?’
We may have fallen victim to cognitive bias by placing less weight on the facts in front of us and instead wallowing in the pain of our past mistake. While we have been ‘waiting and seeing’, Centrica shares have gained 33% over the last two months.
As Shares can attest to, it is hard to ignore the past and only focus on what is in front of you, but it is well worth the effort.
Consciously focus on the salient facts and at least try to place less weight on prior information which may be out of date or less relevant.