A cat who sits on a hot stove will never sit on a hot stove again, but he will probably never sit on a cold one either. – Mark Twain
A recent survey by Bankrate.com found that over half of Americans don’t have any money invested in the stock market. While those that don’t invest in the market gave many reasons why, the underlying reason appears to be a fear of losing money.
Yet for at least the last 100 years long-term investment in the stock market has been the most dependable way to build wealth. What explains our fear of losing money in the market with the reality that stocks have historically been a great investment?
When I was younger I thought I wanted to be a high school teacher and coach. I got a teaching degree and coached basketball and soccer for several years in junior high and high school. During this time I asked all the coaches I worked with if they enjoyed what they were doing.
They all said they loved working with the kids, and they all had a love of the game they were coaching, but all of them said the losses were very hard to take. This was true no matter how successful the coaches were. No matter how often they won, the pleasure they gained from the wins was overshadowed by the pain of the losses.
Although I didn’t know it at the time I was seeing evidence of what behavioral economists have come to call loss aversion. While I didn’t try to quantify how much worse the pain of a loss in sports is than the pleasure of a win, behavioral economists have done this with money.
It turns out that money losses are about 2.5 times more powerful emotionally than money gains. This was summed up nicely by famous investor Ken Fisher:
“…Americans…hate losses about two and a half times as much as they like gains. A 25 percent gain feels about as good as a 10 percent loss feels bad. Said otherwise, if you gain 10 percent over here and lose 10 percent over there, you feel like you’re behind. You feel more chilled by a 10 percent loss than thrilled by a 10 percent gain.”
Loss aversion explains why many Americans don’t invest in the stock market, but it doesn’t make it a wise choice. Since stocks have proven to be the best builder of wealth over the long-term, I believe everyone should have at least some money invested in stocks. If you were burned in the past, be smarter than the cat Mark Twain referenced in the opening quote, and don’t stop in investing in the stock market all together.
In my next post I will teach you how to overcome loss aversion, and how to put the odds in your favor when investing in the stock market. Stay tuned.