A Simple Plan for Managing Pain
Does the idea of losing money cause you anguish?
For most people, it does. In fact, there is plenty of academic research that demonstrates that humans feel the sting of a loss twice as acutely as they do the joy of making an equivalent gain1. In other words, if a $20 bill fell out of the hole in your pocket you would feel the disappointment of loss far more than the joy you might feel upon finding $20 while strolling down the sidewalk.
This might sound rather irrational, and indeed it is! However, this heightened emotional response to losses seems to be hardwired into human nature. We recently read a paper written by Columbia Business School assistant professor Michaela Pagel2, which provided one straightforward piece of advice on how to overcome this hardwiring to achieve better investing outcomes. Below you’ll find an excerpt from an article by Columbia Business School’s Ideas at Work program summarizing Pagels’ research.
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Because the prospect of losing money inflicts so much pain, it bears heavily on how investors perceive risk and make decisions, Pagel’s model shows. “Viewed over a long horizon, the stock market appears relatively safe, because historically it has typically gone up,” she explains. “There’s a pretty good chance the market will go down on any given day or week, but the probability of loss is much lower when you look over a long-run period such as two decades.”
Applied to a retirement portfolio, that suggests that the happiness of an investor who tracks his portfolio day-to-day will be offset by his unhappiness during down markets; flinching at every market dip, big or small, he’ll be more likely to react in ways that damage his portfolio over the long term, for example, by choosing a very low share in risky assets, which impedes the potential growth of his portfolio.
“If you are always more unhappy when you get bad news than you are happy when you get good news, that implies that, on average, looking up your portfolio is painful,” Pagel says. “Most people, if forced to look at their portfolio every single day, would make a very poor investment decision — they would find it so painful that they would not invest anything.” The solution? Check less often.
Source: Want to Grow Your Retirement Savings? Then Forget About It., Columbia Business School Research Feature, October 23, 2014. Image used with permission: iStock.com/robynmac.
1. The economic theory underpinning this idea was first advanced as “Prospect Theory” in a 1979 academic paper by Daniel Kahneman and Amos Tversky. In 2011, Kahneman published “Thinking, Fast and Slow” which condensed his prize-winning research into a bestseller, which we highly recommend to interested readers. 2. To read more of Michaela Pagel’s research, click here.