Investors Focused on Loss Aversion Fall Behind
Financial markets have been volatile recently. That might not change for a while. What is a savvy investor to do?
To understand the right moves in challenging times, we need experience, discipline, and some knowledge of psychology too. The human mind is full of cognitive biases that make us all prone to certain kinds of investing errors.
One of the hardest habits for many investors to break is anchoring. Investing is a forward-looking activity, but humans have a strong bias towards looking backward and attaching ourselves to things we had in the past. Many psychology experiments have verified that humans value something more if we’ve already had it, than if we just stand to gain it for the first time.
This is closely linked to the concept of loss aversion. People hate losing something even more than they like gaining the same thing. Think of a gambler who has lost money at the casino. To get back to breakeven, he will often take on far more risk than he would have taken to win that money in the first place. The human tendency to ride out losing bets, or double down, hoping to get whole, is one of the reasons casinos are so profitable.
But hope is not a strategy, and looking backward only blinds us to the best opportunities in the present. To offset the bias toward anchoring, I like to regularly ask myself, knowing what I know now, would I make this same investment again? If the answer is not an emphatic yes, then I know I should consider finding a better place to invest my capital.
These biases are built into our minds, which did not evolve to make long-term financial decisions. The first step to overcoming these biases is to be aware that they exist. Next, we have to self-examine.
There are still compelling investment opportunities. Maybe even more than usual. Alliance continues to seek and find great deals. But investing in these conditions requires fortitude and clarity. Are we thinking about the future, or the past?
