Killik Explains: How loss aversion can hold investors back
By: Tim Bennett
27.06.2019
In the wake of fund manager Neil Woodford’s woes, long-term investors may be tempted to run from shares. This is the wrong reaction, says Tim Bennett.

How loss aversion can hold investors back

Events like the woes being suffered by Neil Woodford’s Equity Income Fund can make long-term investors panicky. This isn’t helpful and here is why.

Background

When we read negative comment, whether in a newspaper or on a website, we are hard-wired to panic. A centuries-old “fight or flight” reflex kicks in, compelling us to “do something” when sometimes the best course of action is to do nothing at all.

The observation

The reason this isn’t easy is that the reflex I just described also leads us to feel more pain from losses than we derive pleasure from gains. Back on the savanna, catching the next meal was satisfying but not if it came at the risk of injury. Investors feel this “loss aversion” and will tend to conserve what they have, rather than risk it to get more.

A bit of maths

This is mathematically logical too. It is harder, in percentage terms, to recover a loss than make a gain as this simple example shows;

The “Sage of Omaha”

Adding to the pressure on investors not to make a mistake are the words of one of the world’s most successful investors ever, Warren Buffett;
So, plenty of reasons to be “loss-averse” then? Well, it all depends what you mean by a loss.

An obsession with loss aversion can lead to…

Whilst not wanting to take unnecessary risk is entirely rational, avoiding even the chance of a short-term loss is not. Taken too far, it can lead to three problems;

What is a “loss” anyway?

Investing is all about trade-offs and investors who run to cash at the first sign of trouble are missing a big one – yes, shares can be volatile in the short-term and even bring down seasoned professionals such as Neil Woodford. However, over the long-term they have shown that they are less risky than cash in terms of their ability to deliver inflation-beating returns. This extract from my “How to Invest in Equities” Guide makes the point;
Looked at another way, cash leaves you gradually worse and worse off over time;
The point? Short-term volatility is the price of longer-term returns. Investors therefore must avoid confusing this with “risk”.

Conclusion

No-one likes to lose money. However, the correct approach to equity investing reduces the chances, whilst offering the opportunity to make real purchasing power gains. The key to getting your approach right is planning.
To sum up, whilst no-one should be blasé about events such as the Woodford fund’s fall from grace, this sort of event shouldn’t trigger a knee-jerk reaction more widely. To discuss this theme in more detail, please contact an Investment Manager, or email me at the usual place.