Why we're bad at investing part 5: We are risk averse

Entrepreneurs are no strangers to loss.

Cost overruns. Failed launches. Bad debts. Theft. The number of obstacles you’ve dealt with over the years are so many that you probably don’t remember the majority of them. But you don’t let it faze you—because you can’t.

But investing in liquid markets is different, primarily due to the immediacy of the feedback as prices fluctuate, and how it can lead us to constantly second-guess ourselves. Professional investors are well acquainted with prospect theory, from the famous 1979 Kahneman/Tversky study laying out all of the ways that humans behave irrationally in the face of uncertainty. This study forms the cornerstone of modern behavioral finance theory, and it says a lot about how we think about risk.

One of the main conclusions from this paper is that losses hurt more than gains feel good. For example, the average person would rather keep $100 they have in their pocket than risk it for a chance to have $250, even if it’s a 50/50 proposition. In this case, the expected value of the wager is $125, and the rational response is always to take the bet, but most people don’t, and you can attribute that to loss aversion.

When it comes to investing, this plays out in many ways.

I’ve had clients bring me a large sum—say, the proceeds from the sale of a business—and insist that the capital amount should never go below that number. This is a promise that it is impossible to keep with any assurance.

It prevents us from taking smart and well-calculated risks for fear of losing money.

Loss aversion also causes investors to sell when they shouldn’t.

It’s a problem especially faced by investors who are new to public markets, who are often spooked by volatility which proves to be temporary. A huge part of investing successfully in liquid markets is being able to tune out the noise of short term price moves and to focus on the long-term value of the assets you own. It’s arguably the hardest part of investing in the stock market. In future posts I will elaborate on the ways investors can focus on the things that matter.