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Managing Behavior Through (Behavioral) Finance: Part II - Loss Inversion & Inertia

| June 15, 2018
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To begin this article, we want you to first think of the worst stock market timeframes of your lifetime. Got it? Our guess would be that all of you named the great recession, most of you named the bursting of the tech bubble at the turn of the century, and perhaps some of you, if you are old enough, named Black Monday (the infamous crash in the late 80s) and the stagflation market malaise of the mid-70s. Now we want you to think of the very best years of the market – a little more difficult, right? Why is that? We human beings tend to focus significantly more on the times we lose big rather than the times we gain big. As a result, we are much more sensitive to loss than to risk/return, and this can sometimes negatively affect our decision-making. In behavioral finance, this is referred to as loss aversion, or people's tendency to prefer avoiding losses to acquiring equivalent gains.

Now we also want you to think about either yourself or a family member/friend who (understandably) got nervous during the great recession and pulled out of the market/shifted their portfolio to a more conservative allocation. Can you think of that person? How long did it take for them to get back into the market? 2 years? 5 years? Are they back in the market at all? One of the definitions of inertia in Merriam Webster’s dictionary is the “indisposition to change,” and even investors can fall prey to the pitfalls of inertia.

In this article, we will explore loss aversion/inertia, and how it can best be avoided in order to make better financial decisions. If you missed last month’s article (Part I), feel free to refer to such article where we discuss the first behavioral bias – overconfidence.

Averting Losses

There have been numerous studies which have examined loss aversion. In a 2002 study, it was found that people weigh losses more than twice as heavily as potential gains[1]. For example, they found that most people require an even (50/50) chance of a gain of £2,500 in a gamble to offset an even chance of a loss of £1,000 before they find it attractive.[2] Also, the same study found that people tend to avoid locking in a loss as well.

We have seen this numerous times in our own practice. Our clients sometimes want certain stock purchased, and there are always winners and losers. But when we have seen the losers occur, they simply do not want to sell and believe the specific stock will make a comeback (which dovetails with last month’s overconfidence bias). For example, if someone purchased a stock for $1,000, they would have a greater desire to sell the stock if it rose to $1,500 vs. if it dropped to $500. People actually lose tremendous sums of money gambling for the same reason – they desire to get back to even, so they will continue to double and triple their bets to erase their loss. Thus, rather counterintuitively, the investor shows highly risk-averse behavior when facing a profit (selling and locking in the sure gain) and more risk tolerant or risk seeking behavior when facing a loss (continuing to hold the investment and hoping its price rises again).[3]

This idea, where individuals tend to sell winners and hold on to losers, became a theory known as “Disposition Effect.”[4] This idea was later tested by professors at Cal Davis, who utilized data from a US retail brokerage. They found that investors were approximately 50% more likely to sell a winning position than a losing position, despite the fact that the IRS makes it more advantageous to defer locking in gains for as long as possible (due to capital gain rates), while taking tax losses as early as possible.[5] They also found that the tendency to sell winners and hold losers harmed investment returns.[6]

How to Lose Loss Aversion

This area of behavioral finance is probably the toughest area to avoid, because it requires you to sell a losing investment and take a loss. We’ve yet to meet a single person who will happily do so, but it still may be the smart thing to do. Typically, this is where a third party’s opinion (an advisor, friend, someone detached) can objectively evaluate the investment and offer another lens from which to view the situation.

The Paralysis of Inertia

Emotions can play a significant role in the actions we take, but they can play just as important of a role in the actions we don’t. Our emotions can sway us from an agreed course of action – we humans have “second thoughts.” The human desire to avoid regret drives this behavior. Inertia can act as a barrier to effective financial planning, stopping people from saving and making necessary changes to their portfolios.

The example we utilized above is a common one we have seen numerous times – a client should make a change to a portfolio (one we recommend), but the uncertainty of the merits of the decision paralyzes the client, and the most convenient path is one of “wait and see.”

Inertia is not seen only in investment decisions. We also see inertia when it comes to saving for retirement. People cannot decide upon an amount or when to start saving for retirement, and thus do not begin saving until it is too late. Inertia also rears its ugly head when it comes to purchasing insurance – someone cannot make a decision on whether to buy insurance (whether it is life, disability or LTC) or a certain amount/type of coverage. They put off the decision, and sometimes it does not end up hurting them – they do not die, become disabled, or require LTC, or their health remains above board. But there are those times where they do decide to make a decision after years of contemplation, but they cannot obtain the insurance due to a health change (sometimes the impetus for the decision is due to the health change). And, there are those regrettable events where the worst has occurred as well.

However, the biggest type of inertia inducing event is completing one’s estate planning. It is understandable why – there are very large, important decisions that need to be decided, including a division of assets, guardians/trustees for your children (if applicable), healthcare decisions (under what events it is OK for your life to end, etc.). These are not easy decisions, and can cause significant inertia. However, the worst decision of all is no decision, as you are leaving key decisions to state laws/the courts instead of your own volition/your family.

Overcoming Inertia

There are a few different ways to overcome inertia. First, when it comes to saving for retirement, an autopilot scheme is a great way to force saving without the realization that you are doing so. This autopilot scheme was tested with 401ks in the mid 2000s, whereby a small US manufacturing firm was concerned about its employees’ low levels of contributions to their workplace plan (again, inertia!). Two professors – Richard Thaler and Cass Sunstein – enacted a savings plan whereby the employees would commit to increasing their 401k contributions with each subsequent pay raise (thus the “pain” of less take home pay is lessened while the savings rate increased). The participants of this savings plan were saving significantly more on average than those who did not opt in to the savings plan.

We recommend doing the exact same thing, since it does work well, but with one extra step. First, set up auto contributions from your paycheck directly into your 401k (just as these employees did) - you will not miss the money in your bank account since it is coming directly from your pay. However, while some plans have enacted the auto increase in savings rates with pay increases (per the savings plan created by the two professors above), most have not, meaning that you will most likely have to remember to increase your 401k contributions with pay increases. This will require overcoming some inertia, but there is a step you can take to do this.

Inertia is primarily caused because you do not have a gentle “push” to signal you to make a decision. One way that this has been overcome is by setting a decision point – this can either be an event date that is out of your control or a set date that you create – where you tell yourself you will make a decision and stick to it; note this is only half the battle. For example, for a set event date, this can be when you receive a raise – you know then that you must increase your 401k. On the other hand, you can simply tell yourself that “I am going to get my estate planning completed by x date.” We stated this was only half the battle because you need someone to hold you accountable. This can be your financial advisor, a family member, a friend, anyone who can simply ask “hey did you get X done?” By setting a timeframe and having someone hold you accountable, you take the procrastination that comes with inertia out of the picture.

If you have any questions about this or any other area of behavioral finance, please feel free to reach out to Anthony or I.

[1] Montier, James (2002) Behavioural Finance Wiley p21-22.

[2]Id.

[3] Daniel Kahneman and Amos Tversky (1979) ‘Prospect Theory: An analysis of decision making under risk’ Econometrica 47:2, pp. 263-291.

[4]The Journal of Finance, Volume 40, Issue 3, Papers and Proceedings of the Forty Third Annual Meeting American Finance Association, Dallas, Texas, December 28-30, 1984 (Jul., 1985), 777-790.

[5] Brad Barber and Terrence Odean (1999) ‘The courage of misguided convictions’ Financial Analysts Journal, November/December, pp 41-55.

[6]Id.

Karen DeRose and Anthony DeRose are registered representatives of Lincoln Financial Advisors Corp.

Securities and investment advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (Member SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. Ryan Financial Group is not an affiliate of Lincoln Financial Advisors.

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