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Keeping track of mental accounts
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CharmaineLim
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21-Feb-2007 20:18
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lg_6273
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21-Feb-2007 19:40
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Keeping track of mental accounts
An instinctive aversion to loss can lead to poor investment decisions. Understanding that will help investors realign their goals
By PHILIPPA HUCKLE, Published February 21, 2007
AS humans, we are blessed with the wonderful capacity to feel emotions. These feelings weave together in a complex psychology that enables us to think, to act and find meaning, self-expression and fulfilment in life. Yet ironically, it is our psychological make-up that creates a handicap when it comes to investing. Emotionally, we are not built to coolly and calmly evaluate decisions in the face of risk. Because we are human, we experience feelings. And if left unchecked, these can override our rational minds and lead to sub-standard investment decisions.
Over thousands of years, humanity has refined a mental process that causes us to shy away instinctively from situations that could result in a loss. With our 'survival' at stake, we have genetically programmed ourselves to feel losses much more deeply than gains of the same magnitude. So at the heart of every decision-making process is the fact that people are loss-averse. In the world of finance and investing, not only do we fear financial loss, we also fear feeling responsible for the bad decisions that caused the loss.
So, loss aversion means financial decisions can be driven more by the fear of losing than by the hope of winning. How does this process work psychologically?
Most investors sub-consciously catagorise their investments into separate 'mental accounts'. And through these accounts, they keep track of gains and losses relative to the purchase price. So when investors need cash, they instinctively tend to sell those investments that are above their original purchase price, and hold those that are below. This psychological reaction temporarily postpones the unpleasant experience of loss and regret. Yet the correct rational behaviour would be to evaluate the quality of each investment, sell the poorer-quality ones and keep the better ones, irrespective of whether they are above or below the purchase price.
Sticking to status quo
To compound the problem, loss aversion makes it psychologically difficult for investors to restructure their portfolio. Rather than decisively positioning their investments for the future, loss aversion encourages most investors to strongly favour the status quo. It's tempting to delay the pain of financial loss - and the feelings of guilt associated with it - by opting out of emotionally challenging restructuring decisions. Since a paper loss is less painful than a realised one, people are inclined to hang on to poor investments in the hope that some day, things will improve of their own accord. Unfortunately, delaying tough decisions does not fix a problem - it only postpones the pain.
Loss aversion has a similar effect during political elections. As long as current conditions are more or less acceptable, voters are likely to play it safe and opt for the incumbent. The challenger only gets an edge when the state of affairs is so unbearable it cannot be tolerated any longer.
In its worst form, loss aversion causes investors to inadvertently end up distorting the risk parameters of their portfolio. It is not unusual for investors intent on avoiding loss to unwittingly take on even greater risk. The 1995 collapse of Barings Bank is probably the most dramatic example. Because Nick Leeson found it psychologically impossible to accept the reality of the massive trading losses he had incurred, he kept doubling his gambles in a fruitless effort to escape the inevitable pain of loss. But of course every time he doubled, he doubled his risk. Not only did he amplify his chances of losing, he also multiplied the amount at stake. When these losses were inevitably realised, Barings collapsed under their weight.
When the herd is no help
Regret aversion is responsible for herding behaviour. The comfort of a crowd alleviates the feeling of responsibility for a poor decision. After all, a mistake seems more excusable if many people have made the same error. But the danger is that if a decision is indeed poor or irrational, a crowd only serves to exaggerate and enlarge its impact. This is why booms and busts are so spectacular in their magnitude.
Loss aversion is also the reason many investors tend not to restructure inherited portfolios, even if the inherited asset allocation is way out of sync with the appropriate risk/return parameters of their long-term financial objectives. We are afraid of making the wrong decision and losing a loved one's hard-earned money. And we don't want to feel guilty. The hard facts are that although it is a normal human reaction to be unduly conservative with inherited money, financially it is simply not rational. It helps to remember that a benefactor's ultimate intention is to improve the life and future of a person they cared for. An inheritance should be systematically reallocated and co-ordinated with the risk parameters of your total capital to ultimately position you for the best possible financial outcome - just as your benefactor intended.
Mental accounting, loss aversion, regret aversion, status quo bias and herding are potent psychological combinations that explain why investors tend to hold on to poor investments, chase performance and fail to properly restructure their portfolios. By understanding how loss aversion distorts your perception of risk, you can instead choose to make more consciously informed portfolio decisions that reflect your life-time goals rather than your fears.
The writer runs a Hong Kong-based investment advisory firm, The Philippa Huckle Group. This is the first of a series on behavioural finance issues
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