Why Loss Aversion Matters to Long-Term Investors

This is Brad Barrie, Chief Investment Officer and Portfolio Manager with Dynamic Wealth Group.

Welcome to this market and economic update. The S&P 500 index recently reached new all-time highs and broke above 5,000, less than three years since it first crossed the 4,000 mark.

While this is positive news and investors should continue to focus on the long run, it’s also the case that investors should focus on managing risk and staying diversified. This is because market volatility is inevitable, and how we react to market swings matters just as much as how we position for the long run.

In the next few minutes, we’ll cover a few key principles when it comes to understanding investment returns and how they impact investor decisions.

First, this chart shows the breakeven returns needed to recoup a certain loss. For example, a 10% investment loss would require an 11.1% return to make up the difference.

For some this may seem odd at first, but this is just based on the way percentages are calculated. For example, take a look at the bars for a 50% loss. A 50% loss means that you’ve lost half the value of something. So, in order to get back to the original full value, you would need a 100% gain. This makes sense intuitively and is also how investment returns operate.

The problem is that investors may find it daunting to have to gain 25%, 43%, 67%, or 100% to recoup their losses. In the worst case, investors may give up on investing altogether.

We know that long term the market can average attractive returns. And unfortunately, many believe this average return is what they will realize year in and year out. Unfortunately, that is not the case. There is an old saying, “Averages mean nothing, if they did, I could put one foot in a bucket of ice water, and another foot in a bucket of boiling water.” You see, we don’t feel a long-term average, we feel the extremes! And with investing, we feel the downward extreme as risk.

So, it is vital that we manage downside risk by incorporating non-correlated investments that can help to smooth out the investment return experience.

Second, it’s important to bring up a concept called “loss aversion.” This is simply the idea that losses feel worse to us than similar gains. For example, if you found $20 on the ground, you would probably be quite happy. But if you dropped $20 from your wallet, or if this were stolen from you, you might feel considerably worse.

This gap between how gains and losses feel grows as the amount increases. In the extreme, investors may even give up on investing when they hit large enough losses. We know this to be true in 2008, 2020, and so on.

So, it’s important to stay diversified to have a smoother ride. This chart shows that while the all-stock portfolio would have generated the best return, very few investors have the stomach for the level of swings it experiences. Instead, having a properly diversified portfolio linked to one’s specific risk tolerance, time frame and goals is key.

Finally, the sequence of returns matters as well – specifically, whether investors experience good or bad markets first.

When investors experience bad markets first, they may be tempted to give up altogether. Additionally, the math of investing works out such that withdrawals from these portfolios don’t have the benefit of compound interest, lowering the final portfolio values.

Thus, it’s critical that investors understand their financial and investment situations in this environment. Not only should they put themselves in a position to succeed over years and decades, but they should understand their withdrawal rates relative to their financial plans.

We hope you found these insights helpful. If you would like to discuss any of these topics in more detail, please don’t hesitate to reach out. We look forward to speaking with you.


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