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Wednesday, July 15, 2015

Why Are Investors Afraid Of Opportunity Losses More Than Actual Losses?

Since I began investing about 5 years ago, I developed a state of consciousness and conclusion that investors are actually afraid of losing more opportunity losses than actual losses. This conclusion was made through a series of events, including looking at fellow investors' activities as well as experiencing some of the investing decision myself.

This of course does not simply apply to investing alone. In fact, we see this sort of behavior in almost every aspect of life. We try to keep up with the Joneses, buy diamonds that are bigger, go to vacation destinations that are more exotic than the norm, etc. We are always constantly comparing ourselves with the people we know because we want to be better ahead, even if we are already winning the game ourselves.




We, as investors, regardless of whether we subscribe to the risk taker or risk averse mentality, are aware of the risk of permanent loss of capital that we may be subjected to when we invest. Nevertheless, we still believe that stocks represent a long term investment that can multiply our returns over time. Some of us subscribe to fundamental value investing while the prevalent may be towards more of technical analysis these days. The level of individual activities in investing is of the belief that one can perform better than the average people does and if we compound these returns over time, this can add up quite substantially.

Take bonds for example which are assets that grown to be relatively unpopular in Singapore (as compared to stocks and properties). Most of us know the basic of how bonds work as an assets. As a bondholder, we are essentially providing loans to the government (or companies) and in return we get a fixed percentage of coupon paid to us. The main reason I can think of why bonds are generally unpopular with the community is because they offer a fixed percentage of coupon rate until maturity that are stagnant without accounting any "growth" or "increment". Again, because we are a bondholder instead of equity holder, we are not entitled to any growth a business owner would enjoy. This was not helped by the fact that in recent years, we have liquidity favoring the equity market because of low interest rates. By using this logic, investors flock to hot assets like property and stocks that provide supposedly higher returns for them and investors do not certainly want to miss out on these opportunities while liquidity is pushing these assets up.

The STI ETF or the Permanent Portfolio structure is another example of proven returns based on a long term historical data available. Investors could simply stick by the simple investing principle and enjoy decent returns over the long run. However, many investors do not choose to do so because they are afraid of losing more opportunity losses if they didn't invest elsewhere, especially highly driven assets at certain point of time. The high level of individual activities has instead returned them lower returns than these simple investing methods because they aren't capable beating the system.

This could well go down due to psychological matter and the notion that more activities in investing results in higher returns over the long run. It's probably akin to going in to a casino and yet you're spending your precious time playing the slot all night along.

I have not even included people who are in a binary position of all in cash versus all out cash. Talk about the investors from the 2008, 2011 and 2015 I just mentioned in my previous post. Hmm.

Are you like that too? Why do you think investors are more afraid of opportunity losses than the actual losses?


9 comments:

  1. Avoid large losses?

    Prevention is better than cure?

    ReplyDelete
    Replies
    1. Hi Uncle CW

      I think there are also plenty of investors who bought out of fear of missing out but ended up with large losses because they are buying near the peak. At the end of the day, I think valuations still matter to investors.

      Delete
  2. I don't know about other people, but I didn't have much cash in 2009. I guess, I didn't want to suddenly lose a lot of money in the stock market, in case I need the cash. During this same period I had $2-10K in the stock market and was losing money. Not being educated and experiences through recession, I did leave it alone for a long period of time and stop contributing. Obviously missed the 5-year bull run (for my taxable account). You'll have to live through 2-3 recessions before you can trust that the market will bounce back.

    ReplyDelete
    Replies
    1. Hi Vivianne

      You are treating cash as a call option. I like that.

      Even though mathematically speaking cash is a drag on the overall returns for one's portfolio in the long run, it gives us the option to be able to utilize them during periods of maximum uncertainty.

      I am keeping some cash on the sideline for the big game as well.

      Delete
  3. I belong to the avoid actual-losses group. I believe not losing money is battle half-won.

    However, I am still doing my research how to ride the market during bull market like now as I have waited for the bear for 5 years. Can't imagine how much opportunity cost I have missed. During 2009-2010, I bought, earned 150% profit and sold them off within 1 year. Balance sheet was very green, but it could be much better. The good thing now is I know what to do during the next bear market, I guess.

    Obviously, I am not competing with anyone to prove anything. My target is constant. My answer is asset allocation strategy, which I have done recently.

    ReplyDelete
  4. Hi Frugal Daddy

    I saw your allocation strategy during certain market situations and thought that is impressive. The difficult part is sticking to it through thick and thin and I have seen many investors give that up halfway. Hope you'll be able to persevere and see through the light once final day.

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  5. What you describe is commonly known by the behavioral economists as loss aversion. These guys have proven that—emotionally—a loss "weighs" at least twice that of a similar gain.

    Thanks to our generous bias generator aka brain we cannot separate emotions from decision making.

    I try to prepare myself emotionally by accepting the possibility of losses as part of the game, not the end of the game. Only the overall portfolio performance matters.

    To increase the chances of a positive portfolio development I have a predetermined automatic stop loss for each of my positions in place to keep losses small. If I get stopped out, I take notice and move on to another counter.

    I strongly believe that time in the market is our greatest advantage compared to the Wall Street Big Money (some call it the Smart Money, why?). We do not have to show a profit to our shareholders every month.

    And of course greed also plays a role in the scenarios you describe. A solid upfront documented diversification strategy into different asset classes can help here. Naturally combined with adhering to it no matter what.

    ReplyDelete
    Replies
    1. Hi Tacomob

      Thanks for the great advice.

      Emotionally speaking, anything that is a loss weighs much more than anything that is a gain. They are psychologically proven that humans are more inclined towards afraid of losing than going for winning.

      Delete
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    ReplyDelete

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