Humans hate to lose. In fact, behavioral economists tell us when it comes to money we hate losing more than twice as much as we like winning. This is called loss aversion, and if we are not careful it can lead to irrational investing decisions.
Paul Samuelson, noble winning economist, once tested this theory by asking a colleague if he would accept a bet on a coin toss. If it was heads Samuelson would give his colleague $200, and if it was tails his colleague would give him $100. The terms of the bet were obviously beneficial to Samuelson’s colleague, but as the theory of loss aversion would predict his colleague turned down the offer.
However, his colleague came back with a counter offer. He would accept the bet if he could do it not once, but 100 times, and if he didn’t have to watch while the coin was being tossed. Samuelson’s colleague, whose name is lost to history as far as I can tell, had hit upon two key strategies for overcoming loss aversion in investing:
- Play as much as possible. When the odds are in your favor, but there is risk of losing, don’t avoid the game. Play a lot.
- Don’t watch. Don’t monitor short-term results. Instead, focus on long-term goals.
MIT Students vs. the Massachusetts Lottery
Playing the lottery is usually a terrible financial decision. In fact, the lottery is sometimes described as “a tax on people who can’t do math”. This is almost always true, but in his excellent book How Not to Be Wrong: The Power of Mathematical Thinking, Jordan Ellenberg tells about a Massachusetts Lottery game called Cash WinFall that was so poorly designed that under certain circumstances a $2 lottery ticket had an expected value of $5.53.
Ellenberg points out that an expected value is not the value you expect to get from purchasing a single ticket. In fact, it would be impossible to win $5.53 from a single Cash WinFall lottery ticket, and the odds are high that any single ticket you purchased would be worthless. However, if you bought enough tickets (perhaps 1,000 or more) you would average about $5.53 per ticket.
A group of MIT students figured this out and pooled their money to purchase thousands of Cash WinFall tickets every time the conditions were right. They did this for several years and made a lot of easy money before the lottery officials wised up and changed the rules. For the students this wasn’t gambling, it was almost a sure thing. As Ellenberg puts it, “If gambling is exciting, you’re doing it wrong.”
Loss Aversion & Investing
Over the long-term investing in the stock market also has a positive expected value because over time the market rises. This is true only if you are investing in the market as a whole, not individual stocks. Trying to find the next Apple is more like buying a lottery ticket, but with slightly better odds.
Investing in the market as a whole is done through index funds. For example, you can purchase an S&P 500 index fund that invests in all of the stocks making up the S&P 500 index. These are 500 of the biggest US companies, and over the years the S&P 500 has been a good proxy for the stock market as a whole. Even broader-based index funds are available, and it is now possible to purchase a single index fund that invests in stocks world-wide.
Every time you invest in an S&P 500 index fund it is like making 500 small bets (500 coin tosses) on 500 different companies. Not all of these bets will work out in your favor but over many years, if history is a guide, you will come out with a very favorable return.
This is especially true if you invest at regular intervals (for example each time you get paid) over a long period of time. While betting on a single company by purchasing stock one time might not be wise, investing in an index fund hundreds of times over many years is more like what Samuelson’s colleague was proposing, and what the MIT students were doing with Cash WinFall. While success is not guaranteed, investing in this manner puts the odds of success heavily in your favor.
This type of investing is in harmony with the Micawber Principle Laws of Success and Probability. Rule number 3 states, “If you understand the odds, and they are in your favor, play the game as often, and for as long as you can.” Investing like this might not be terribly exciting, but it is smart. As Ellenberg concludes, “If investing is exciting…”
“You’re going to get a statement every month. Don’t open it. Never open it. Don’t peek.” Bogle adds that after you retire, you should open the envelope.
Now, I am not advocating that you never look at your investment performance until retirement, and I am not sure that Bogle really is. I think he is exaggerating to make a point. You do need to check occasionally to rebalance your account, adjust the amount you are saving, and make sure your plan still makes sense.
I am suggesting that you don’t need to check the performance of your investments daily, weekly, or even monthly. Checking too frequently increases the chance that you will get bad short-term news that won’t really matter as far as reaching your long-term goals. If you act irrationally based on the bad short-term news, as humans tend to do, you can do serious damage to your long-term plans.
This is illustrated by a popular story told in financial circles. The story is probably not true, but the principle it illustrates is:
A woman invests $10,000 dollars in a mutual fund in the mid-1970s. She is investing for the long-term, so she carries on with her life and almost forgets it is there. When she hears about the market crash in October of 1987 she calls the investment company in a panic. The employee who answers the phone checks on her investment and tells her, “I’m sorry, madam, but the value of your fund holdings has fallen to $179,623.”
This illustrates that short-term losses, even if they are significant, are almost never great enough to counteract the long-term tendency of the stock market to rise.
So how often should you check your investment’s performance? Many advisors think a yearly “peek” is frequent enough to make necessary adjustments but infrequent enough to lesson your chance of overreacting to bad news.
Greg Forsythe, writing in Schwab’s On Investing magazine, wrote “The more often you check your portfolio the more likely you’ll see something going down in price and expose yourself to loss-driven emotions. During the past 75 years the S&P 500 Index has been down in 46.2% of all days, but that falls to 40.0% when you look at all months and only 29.8% when you look at years.”
Also, if you only check once per year, even if you are down – as you probably will be almost a third of the time – you only get the bad news once. If you check daily it can sometimes feel like an avalanche of bad news when the market goes through a rough patch.
So there you have it. The two keys to overcoming your fear of investing in stocks. First, play as often and for as long as you can. The odds are in your favor in the long run, and each bet you place is one of many that won’t make or break your plan.
Second, don’t peak. Or at least don’t peak too frequently. Ignore short-term results and focus on the big picture. These two strategies will allow you to overcome your fear of losing money and take the risk you need in order reach your long-term goals.