Should we be taking more investment risk?
Real life data on investor behaviour suggests we may be less averse to losses than we think. This raises the question: should we take more investment risk?
It’s long been recognised that most people are more sensitive to the prospect of losses than gains. A body of studies suggests that on average an anticipated loss of £100 is felt as keenly as a gain of £200. For example, consider the following gamble:
You are offered the choice between:
A: £1000 for certain.
B: A coin toss leading to £900 if it comes up heads and £Y if it comes up tails.
If Y=£1100, the potential gain from taking the gamble (£100) is the same as the potential loss. In this case, overwhelmingly, people reject the gamble and choose A. If Y=£1150, where the potential gain is 1.5 times the potential loss, most people still reject the gamble and choose A. It’s not until Y=£1200, where the potential gain is 2 times the potential loss, that most people become interested.
In other words, people are loss averse with an average loss aversion factor of around 2. Of course, people are different and may be more or less averse to losses than the average. Y=£1200 won’t be the break-even point for everyone.
Loss aversion and investment strategy
But overall, the core idea is that avoiding losses is more important to us than seeking gains. The concept is fundamental to the question of investment strategy, driving people’s willingness to invest in volatile assets, such as equities, as opposed to less volatile assets, such as bonds. This is an important question because, over the very long term (periods of several decades) equities have tended to deliver substantially higher returns than bonds, but have been much more volatile. If people are put off by loss aversion from taking enough risk, they may not achieve their financial goals. Indeed, in a famous paper nearly 30 years ago, Shlomo Benartzi and Richard Thaler proposed that the surprisingly large observed outperformance by equities can be explained by loss averse investors tending to focus on the short-term volatility of their portfolio.
Most estimates of loss aversion are undertaken using theoretical gambles of the type shown above. What if it’s different in practice? As Daniel Gilbert shows in his book Stumbling on Happiness, we’re often very poor at predicting how we’re going to feel in future. And we often adapt surprisingly quickly to whatever actually happens. Could hedonic adaptation cancel out loss aversion?
What does the data say?
Christophe Merkle tried to address this very question in a paper published last year in the top European finance journal, the Review of Finance. The author had access to a unique database of Barclays Wealth individual investor clients over the period of the financial crisis. Clients were asked to describe how they felt about anticipated and actual losses, and this data was used to infer their loss aversion.
On average, the aversion to anticipated losses was 2 (i.e. losses felt 2 times as keenly as gains) in line with other studies. However, the aversion to realised losses was statistically indistinguishable from 1.
In other words, losses were in reality felt no more keenly than gains. This level of realised loss aversion was the same for groups with low and high anticipated loss aversion. Interestingly, financial knowledge and education acted to close the gap between anticipated and realised loss aversion. Moreover, recently experiencing a loss seemed to make investors less loss averse for a while.
What’s going on? This is all very consistent with Daniel Gilbert’s view that we’re not good at predicting how we’ll feel and that we rapidly adapt to whatever circumstances present themselves. Perhaps loss aversion is just another case of what Gilbert calls ‘miswanting’?
This is just one study on a relatively small sample at one point in time. So we should be modest about what we conclude. But what lessons could we learn? Educating ourselves on investment seems to be a worthwhile thing to do. Severe market falls (think dot.com crash, global financial crisis, COVID-19) are great laboratories for noting how we actually feel when faced with a loss. We should note down the results for future reference. But finally, without ripping up our investment strategy, maybe we could err on the side of slightly more, rather than slightly less, risk. It probably won’t be as bad as we fear.