Investing in Difficult Times # 3
By Coen Welsh – In the previous article I explored the idea of selective memory and cognitive dissonance. I explained that when you invest you should consider all your investment decisions and be careful not to base your self concept in terms of investing, on your top performing investments only. You should consider your whole portfolio and get advice or assistance if necessary.
I started writing this series of articles to expand on a presentation I gave at an investment conference some years ago. The next psychological concept that I want to explore is something we call loss aversion.
The most famous behavioural economists Daniel Kahneman and Amos Tversky described the idea of loss aversion. In a nutshell this means that the loss we experience has a greater impact than the satisfaction we receive from making a gain. This kind of behaviour leads to risk aversion. To illustrate this think of the the parable of the talents in the Bible. The landowner leaves each of his workers with some talents. A talent was an enormous amount of money in those days. The result of the story is that the guy who received the smallest amount was so risk averse that he buried his money and returned the money back to the landowner upon his return. The twist in the story comes when the landowner admonishes and punishes him by taking away his talents and giving it to the one who has the most. Then tell him that he is lazy and at least could have put the money in the bank so that the landowner could get the interest on his money.
The point here is that often we are so averse to the risk and the thought that we may lose something if we invest that we do nothing. We leave our savings in the bank at nominal interest rate and every time the inflation rate is higher than the interest rate you receive you effectively have less. The net effect is that investors are much more comfortable to “cash in” a well performing investment than to get rid of a poor performing investment. In an attempt to prevent any losses an investor will hold on to a poor performing investment for a much longer time, even just to break even.
In some cases an investor may even put more money into such an investment rather than letting it go. For example, let’s say you invested in property. Now the property value is not increasing as you expected. You may decide to renovate the property to attract better tenants. Thus putting more money into the property in the hope that it turns around. This is called sunk cost bias and is something we most clearly see with gamblers. You have already spent N$1000 therefore the payout must be around the corner. This may not be an exact description of sunk cost bias but I believe it explains the point. In investing this plays out such as in the example above. You have already spent so much money, time and effort on this project or investment that it just has to pay off. Therefore we tend to hold on and spend more when in reality the best move would be to stop cut your losses as the saying goes and invest in something else.
To summarise, when we decide to invest we need to find the balance between risk and safety. There is no point in trying to play it safe but losing out in the long run, at the same time there’s no point in risking it all and losing everything.
Disclaimer – I am not a Financial Advisor and the information contained in this article is not financial advice and should not be seen as such. I am an entrepreneur and investor who tries to play the game and make the most of our time here while trying to leave a better place when my time is up.
Coen Welsh, a qualified industrial psychologist is an expert on the Antecedents and underlying Psychological Conditions predicting Employee Engagement.He has worked in diverse teams in the UK, Egypt and Namibia. Coen regularly gets invited to speak at HR and other conferences. He is a regular contributor to NBC National Radio as well as Tupopyeni and Off-the-Hook on NBC Television. He is a founding member of the Professional Speakers Association of Namibia. You can visit him at www.coenwelsh.com or at www.capacitytrust.com.