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INVESTING MAY BE simple, but it’s far from easy. Our mettle is tested during market extremes, whether it’s bubbles or bear markets. Today, both U.S. and international stocks are close to bear market territory. Amazingly, even major bond market segments are sporting double-digit losses, with Vanguard Total Bond Market ETF (symbol: BND) down almost 10% in 2022.
What makes years like this one so difficult is our deep aversion to losses. Successful investing is about balancing risk and reward. But because of loss aversion, most of us place a premium on minimizing losses. For instance, many folks will only bet on a coin toss when the reward for winning is at least twice as great as the potential loss.
The stock market is a favorable bet over the long run. Even on a daily basis, it rises on slightly more days than it falls. But in the short term, the potential upside is nowhere close to double the downside. Result: We often play it too safe, avoiding the stock market “casino” and keeping too much in bonds and cash.
Stanford University researchers Brian Knutson and Camelia Kuhnen used functional MRI scans of brain activity to show that recent losses lead to greater loss aversion and reduced risk-taking. Their study corroborates what we already know about behavior during bear markets: Many investors retreat from stocks at the worst possible moment.
While loss aversion may have conferred survival advantages to our nomadic ancestors, it’s downright counterproductive when it comes to investing. The savviest investors understand this. They learn to conquer their emotions and go against the grain, using fear as a contrarian indicator, and becoming more aggressive when they and others are most afraid.
How can we manage our innate loss aversion more intelligently? A dose of cognitive psychology may help. If our thoughts drive our emotions and our emotions determine how we act, we must begin by changing the way we think. This means reframing investing in three key ways:
1. Focus on dividends and earnings. Long-run stock returns are fundamentally driven by dividends and earnings growth. Yes, there’s a third factor in the market’s performance: changing valuations. But in the short run, that’s fickle, a reflection of investor psychology.
The good news: Stock dividends are far more stable than stock prices, as Nobel prize-winning economist Robert Shiller has shown. Meanwhile, company profits fluctuate with the business cycle. Still, corporate earnings are fairly resilient, growing about 4% per year over the long run.
What does this mean to you as an investor? When the stock market tanks, dividend yields rise, plus those dividends can be reinvested at lower prices. Suppose you’re a part owner of a business that pays a steady dividend. Let’s also assume you take those dividends and reinvest them, thus buying more company stock. If the stock price declines, you’re able to buy more shares with your dividends. The upshot: Assuming the dividend isn’t cut, your dividend stream and ownership stake will grow even faster when stock prices are depressed.
2. Look at the forest, not the trees. How we frame issues can have an enormous impact on our thinking.
Want to minimize the potential damage caused by loss aversion? When you look at your portfolio—which you should do as little as possible—focus on your total balance rather than the net gain or loss. For example, if your portfolio started the year at $500,000 and has lost 10%, the total balance would now be $450,000. Focus on that number rather than on the $50,000 loss.
Similarly, resist looking closely at your individual holdings. It’s human nature to obsess over our losers and forget the benefits of diversification. Such myopic loss aversion will make you miserable, and it may prompt you to dump your losers and add to your winners. That means you’d be selling low and buying high.
Also try viewing your investment portfolio as just one piece of your overall wealth. For most people, their investment portfolio is dwarfed by the value of their home. They likely also have other assets, including Social Security, annuities, pensions and life insurance. These can have substantial value, even if you aren’t currently drawing income from them.
If you’re still in the workforce, your most valuable asset may be your human capital. Suppose you’re age 35. You might have 30 or more years of future earnings before retirement. A back-of-the-envelope calculation will show that the value of your human capital is substantial, and you can convert that into significant wealth if you’re a good saver.
The bottom line: By looking at the big picture, you’ll discover that even large fluctuations in your investment portfolio are often minuscule in the greater scheme of things. During stock market declines, that ought to provide some solace and reduce the sting of loss aversion.
3. Avoid the financial media frenzy. Coming from a financial website, this may seem like strange advice. But not all financial content is created equal. Most financial media outlets have a profit motive. Their goal is to maximize viewership, not educate their viewers. When it comes to news, “If it bleeds, it leads.”
While nothing garners more attention than fearful news, nothing will destroy your wealth faster than acting on those fears. Do yourself a favor during today’s market turmoil and take a break from financial media. Go for a walk, read a book or take up meditation. And try to sleep more. You’ll be healthier and happier and—dare I say?—wealthier.
John Lim is a physician and author of “How to Raise Your Child’s Financial IQ,” which is available as both a free PDF and a Kindle edition. Check out John’s earlier articles.
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I think articles like this often overrate our “human capital.” How many people become involuntary, permanently unemployed before 65? How many become disabled? How many have ginormous medical bills? THIS FEAR is the reason we hold lots of cash, relative to time frame.
But I also think there is generally an underrating of ways to protect against this, like disability insurance. Spekaing personally, it’s tough to know “how much” insurance I need for a house or car, which is more or less a tangible, quantifiable asset. It’s nearly impossible for me to confidently guess “how much” insurance I need for my potential disability and potential earnings loss!
The max benefit I’ve seen at a few companies for disability insurance, a great hedge for a real human capital risk, has been only about 60% of salary. That’s less than ideal to me, but unlike salary disability insurance payments are not taxed. +1 to holding cash to help with other risks to human capital.
For payments from employer-offered disability insurance not to be taxable, make sure your premiums are set up to be deducted from your posttax salary.
This is an excellent article, thank you, and so true
I’ll take issue with the notion of social security being an asset. Assets are generally part of an estate. SS is an income stream. When the SS recipient dies the income stream dies with her.
That’s debatable. I have a pension and SS and both will continue to my wife if that is our future. In a real sense those are our largest guaranteed assets while we survive.
Do you also object to calling our human capital one of our assets?
Assets do not have to flow to an estate to show on the positive side of a balance sheet or net worth statement.
SS, immediate fixed annuities, and deferred income annuities can continue to produce income for a surviving spouse.