The Dow Jones Industrial Average is down over 1,000 points over the past two days and the S&P 500 is down 4% from its Monday open. Ouch. (However, the 4% drop in the market this week means that it is still up a bit over 5% year-to-date and 12% over the past 12 months.)

It is important to remember that when we look at our portfolios and see losses that there’s an asymmetry in how we view gains and losses. Research shows that losses are more painful than gains are pleasurable. This asymmetry is referred to as “loss aversion.” There is an evolutionary reason for our loss aversion.

Rolf Dobelli, in his book The Art of Thinking Clearly notes that there are more bad things than good that seem possible to happen to us in the future and this was even more the case in our evolutionary past. “One stupid mistake and you were dead. Everything could lead to your rapid departure from the game of life – carelessness on the hunt, an inflamed tendon, exclusion from the group and so on. People who were reckless or gung-ho died before they could pass their genes on to the next generation. Those who remained, the cautious, survived. We are their descendants.” Daniel Kahneman in Thinking Fast and Slow notes that “organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.”

The main loss aversion theory was proposed by Daniel Kahneman and Amos Tversky, which they named “Prospect Theory” (they called their theory “prospect theory” merely because it was a catchy and sophisticated sounding name). Their main finding was that “Losses loom larger than gains.” Their research found that losses are about 1.5x – 2x more painful than gains are pleasurable. Here’s a diagram of that concept:

Prospect Theory has a number of interesting takeaways:

• Evaluation of gains and losses are relative to a reference point. Our reference points reset over time and are often high-water marks (meaning that if you hit $1 million of investments and then it drops to $800k, you feel like you’ve lost $200k, even though you only invested $500k to begin with).
  
• There is varying sensitivity with respect to gains and losses. $100 loss is the same dollar amount whether your $1000 goes down to $900 or $200 goes to $100. However, the second one is much more painful. Likewise, loss of $1,000 to someone worth $10 million is quite different than loss of $1,000 to someone worth $10,000.
  
• People tend to choose options with certainty vs. options that are uncertain, even when the certain option is statistically inferior to the uncertain choice.
  
• A very counter-intuitive point: a sure loss is very painful and compels people to take greater risks. Thus, when faced with a loss, people often “double-down” and take more risk to avoid taking a loss.
  

Also from The Art of Thinking Clearly: “We are more sensitive to negative than to positive things. On the street, scary faces stand out more than smiling ones. We remember bad behaviour longer than good – except, of course, when it comes to ourselves.”

But, prospect theory doesn’t take into account regret. From Thinking Fast and Slow:

#1: Choose between 90% chance to win $1 million OR $50 with certainty

#2: Choose between 90% chance to win $1 million OR $150,000 with certainty.

“Compare the anticipated pain of choosing the gamble and not winning in the two cases. Failing to win is a disappointment in both, but the potential pain is compounded in problem 2 by knowing that if you choose the gamble and lose you will regret the ‘greedy’ decision you made by spurning a sure gift of $150,000. In regret, the experience of an outcome depends on an option you could have adopted but did not.”

Investing Advice based on Prospect Theory:

Over long periods of time the market goes up.  Over shorter periods of time the market fluctuates. This leads to the conclusion that the more often you look at your portfolio, the more painful it is (assuming that gains are only 1/2 as pleasurable than losses). Thus, a best practice is to avoid looking at your portfolio often (once a year would be about right).

Here’s a chart showing calendar year returns along with intra-year draw downs. Imagine if you only looked at your portfolio at the end of each calendar year vs. looking at it all the time, and experiencing the intra-year draw downs.

Article I recently wrote on Five Lessons Learned From Lehman’s Collapse

Related IFODs:

 Decision-making under uncertainty and the Ellsberg Paradox

 Conjunction Fallacy and the Linda Problem

 The Endowment Effect

 Decision Making and the Resulting Fallacy

 The Gambler’s Fallacy

 The Sunk Cost Fallacy