Over tens of thousands of years, humans have developed this trait and for most instances in life it has been very useful (in the early days it stopped us getting eaten or being drowned). When it comes to investing however, successful investors embrace risk. Yes, it is managed and studied as far as practical but it is embraced all the same. This is counter intuitive for us all. To demonstrate this natural aversion, consider the following two questions then look to the bottom of this page for the outcome;
Question 1. You have $20,000 to invest. You can choose either;
a). Gain $5,000 right now or,
b). Have a 50% chance of getting $10,000 and a 50% chance of getting nothing.
Question 2. You have $30,000 to invest. You can either;
a). Lose $5,000 right now or;
b). Have a 50% chance of losing $10,000 and a 50% chance of getting nothing.
This behavioural economics survey has been conducted across many thousands of people. What were your answers?
The overwhelming majority chose, ‘a’ in question 1 and ‘a’ in question 2. The statistical outcome however for all four options is an identical $25,000. So why do most follow the same pattern in their answers?
For Q1, it’s about the certainty of taking a gain rather than risking a loss that could produce a higher gain. We humans like certainty. It’s also why we dislike change. For Q2, the certainty of the $5,000 loss and avoiding the risk of a potential loss of $10,000 is hard wired so much into our brains, that most will incur a certain loss rather than be exposed to a possible larger loss. People feel the pain of loss twice as much as a gain. We have written about this to remind our clients of their natural, in-built bias in decision making around losses, gains, and volatility. Whilst its overall a good thing for we humans to possess, it works against us with successful investment decision making over time.
For advice and support when investing
Contact your adviser or click here to drop us a line and someone will be in touch