Hating to Lose Money Can Cost You Big

Imagine that you have been given $1,000, with the following two options:

Option A: You are guaranteed to win an additional $500.

Option B: You can flip a coin, and if it comes up heads receive another $1,000; tails, nothing more.

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Which do you choose?

Now imagine that you are given $2,000, and these two options:

Option A: You are guaranteed to lose $500.

Option B: You can flip a coin, and if it comes up heads, you lose $1,000; tails you lose nothing.

Which do you choose?

Most people (perhaps you?) choose A in the first scenario and B in the second. In both Option A’s, you finish with a sure gain or loss and a final number of $1,500. Option B’s give you an even chance of ending up with $1,000 or $2,000. But think of the choices this way: By choosing A in the first case and B in the second, it shows an inclination to be more conservative if you can lock in a sure profit, but an inclination to be more risky if you potentially can avoid losses.

The idea of losing $500 guaranteed is so painful that you would rather risk $1,000 to avoid that guaranteed loss. Or the idea of letting the $500 slip away in the first scenario for the chance of gaining $1,000, is discomforting enough to cause you to opt for the sure thing.

Here’s how that translates into financial decisions. If you have lost a lot of money in the stock market, there is a temptation to gamble big in the hopes of recouping it. If you have gained money, you have a tendency to be more conservative and lock in gains, even if they are small.

Welcome to Prospect Theory, which says that people assign values to the gains or losses themselves, based on their own merits, or in other words, on the immediate value of the gain or loss. And the pain of loss is a stronger motivator than the reward of gain.

It is the actual gaining or losing, rather than how the gains or losses leave our balance sheets overall, that affects us more. In fact, according to research by Kahneman and Tversky, people react more strongly to the pain that comes with loss than they do to the pleasure that comes with an equal gain.

So if you had $1 million and lost $100,000, you would feel the pain of that loss twice as much as you would feel pleasure from gaining $100,000. Sure, you like the idea of gaining, say, $500 or $1,000, the researchers found, but only because you like winning and dislike losing. And you dislike losing about 1.5 to 2.5 times more than you like winning. This is called the “loss aversion ratio.” It explains why, when faced with tough choices such as where a sure loss is compared to a larger loss that is merely probable, most people will take more risk than they otherwise would.

Is loss aversion a bad thing? Not always. Take lifetime savings for those in retirement or close to retirement. Better to care about falling too far, than continuing to climb to find richer rewards. But oversensitivity to loss can also have negative consequences -- panic selling, for example. The injured want to stop the bleeding. They don’t always consider the misgivings they’ll have when the markets go back up again and they are sitting on the money under their mattress.

According to finance professor H. Nejat Seyhun at the University of Michigan, if you had missed the 90 best-performing days of the stock market from 1963 to 2004, your average annual return would have dropped from almost 11% to slightly less than 3%. That’s 10,573 trading days. If you missed 90, or about 0.85% of the days, a $1,000 investment would have been worth around $3,200, not $74,000.

There’s another pitfall. Loss aversion can cause investors to hold on to losing investments for longer than they should. A revealing study by Terrance Odean (University of California-Berkeley) and Brad Barber (University of California-Davis) found that investors were far more likely to sell stocks that had risen in price than to sell those that had fallen. The researchers analyzed trading records of 10,000 accounts at a large discount brokerage from 1987 to 1993. Their findings: The stocks that the investors had sold outperformed the stocks they had kept by another 3.4%.

Most people are more willing to lock in a sure gain that comes from selling a winning stock or fund than they are willing to lock in a sure loss of selling a losing investment, even though for some good reasons, it makes more sense to sell losers and keep winners. The prospect of selling a losing investment makes investors more willing to hold on in the hope that if they wait long enough, the stock will rise; the risk being that the stock value will remain lower or drop even further. And if they don’t sell, the loss is only a “paper loss.”

Some parting thoughts for consideration: Assume you are more sensitive to losing money than you think. Diversify not just by asset types but by the time frame involved. Consider when you’ll need to draw on the investment. The longer time period you have before you need the money, the more risk you can take, and the more equity investments you can hold.

There is rarely any consistency in the uphill battle to manage one’s portfolio. What ends up being critical is making sure the investment money is there when you need it. If monies are needed in the short run, whether it be for college planning, upcoming housing expenses or travel plans, portfolio holdings and strategies will be directed to those needs. And those holdings will have different characteristics than the part of the portfolio that is earmarked for funds needed in the long term. We call this Portfolio Mapping, where time is used as a primary determining factor in the way you construct a portfolio.

Portfolio Mapping identifies the goals you are trying to achieve and the purposes for your investments to different parts of your overall portfolio. This mapping process allows you to track how well your investments are set up to reach your goals.

What does this mean for investors? As much as you hate losing and love winning, investors who are the real winners develop a plan that allows for the money to be available when it is needed.

Michael Krumholz has run a financial advisory practice for over 25 years. He received an economics degree at Williams College in Williamstown, Mass. He prefers being outside as much as possible playing tennis or biking, enjoys playing the guitar and piano, and is an avid reader.

Investing involves risk of loss. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal.

Registered Representative, Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representa¬tive, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Cambridge and CFG, are not affiliated.