Sometimes investments lose money. It’s inevitable. But the most important thing isn’t that we’ve lost money but what we do about it when it happens. That’s where mastery, experience, skill and good advice come in.
Daniel Kahneman and Amos Tversky built their careers on studying and understanding these thinking errors. Kahneman won the Nobel Prize in economics for this work in 2002. Tversky would have but passed away before.
One of the consistent patterns they found is that a loss had 2 1/2 times the emotional impact of a gain. So, as much as we enjoy when our investments succeed, we hurt 2 1/2 times as much when they don’t. This explains why investors hold on to bad investments or throw good money at their bad investments, trying to salvage what in reality is a lost cause.
Imagine being faced with a choice of accepting a certain loss of $7,500, or a 75% chance of losing $10,000 and a 25% chance of losing nothing. Statistically, the odds of losing $7,500 are exactly the same, but most people will choose the second option with the hope of avoiding any loss at all. Believing, on an emotional level, that they could avoid this loss is a powerful force, which can sometimes lead to disaster.
The big motivator that gets in the way of acknowledging, accepting and rationally acting on an economic loss is not fear, not greed but hope. We don’t want to let go of the possibility that things could somehow turn around and we could avoid the loss entirely.
Loss is one of the main causes of depression, e.g. loss of a loved one, loss of a job, loss of a lifestyle. When we suffer a loss, it’s natural for our mood system to lower our energy so that we can reassess things, make necessary changes, and find ways to adapt and carry on. This is a natural, healthy process, if we pay attention to it. When we lose money on an investment, it’s a time to reassess that investment, to look harder at the fundamentals and to make decisions on what to do next. It’s not the time to deny the reality.
Sometimes that means selling something we had high hopes for. Sometimes that means selling something at a painful loss. But if selling is the right move, then it’s the right move. If we can use the remaining money from a bad investment to buy a much better investment, then that’s what we should do. That may be the start of an important gain.
Of course, nobody wants to lose. The essential thing is to think clearly and honestly when there’s a loss. Being aware of such kind of thinking mistakes can help to turn a painful loss into allowing our overall portfolio to grow and flourish again by simply transferring the remaining money from a bad investment into a successful one.
Sven Franssen