A popular topic in behavioral economics is loss aversion. Studied extensively by Daniel Kahneman and Amos Tversky, loss aversion means you value something you already have at a level above what others would value it. Another way to look at it? You’d rather not lose $5 than find $5 you never had.
Although loss aversion has been a popular topic to study in investing and retail shopping, it also applies to sports. Especially to the game of golf. For instance, during the U.S. Open, the course setup may call for changing the par on certain holes. Par is a measure to tell the golfer the number of strokes he or she is expected to take to complete the hole. This means the tournament coordinators change a hole from a short par 5 to a long par 4.
The change made plays a psychological trick on the competitors. The hole itself hasn’t changed one bit, just the number on the scorecard. Research was conducted to see how much of an effect this has on even the best players in the world.
When a hole was playing as a long par 4, golfers were more aggressive in an attempt to not make a bogey, which is one shot more than par. If the hole was playing as a short par 5, the golfers were more conservative, as a missed shot will still result in a par for the hole. The end result due to a change in behavior? Over four rounds of the tournament, this had an effect of more than a one stroke difference. In golf, this is the often the gap between first and second place.
For investors, the trick of loss aversion can be equally harmful to one’s success. As the saying goes -- “the pain of losses is twice as much as the pleasure of gains”.
In order to protect yourself from this type of behavioral mistake, consider these small steps to be your own best friend:
Separate your money into buckets. Your financial life has various needs and timelines. Your short-term, mid-term, and long-term goals should be invested in different ways. By separating your money into different accounts for their respective goals, loss aversion is tempered. You accept that your long-term goals are going to experience short-term losses, leaving you less likely to sell, because you know your short-term finances are safe.
Rebalance on a regular basis. Investors want to avoid losses so bad that they will hold on to losing investments longer than investments that have gone up in value. Call it optimism or call it persistence, it’s an issue to be avoided. By setting yourself up on a regular rebalancing schedule, you routinely bring your portfolio back in line with its’ intended allocation target.
Take the overnight test. This is a way of thinking I learned from Carl Richards, The Sketch Guy. Imagine you own a stock that you know you should sell because it doesn’t belong in your portfolio. You go to bed one night and the next morning the stock has been replaced by cash. Now you have the option to buy the stock back at the same price or reinvest the cash into the portfolio you know is best for your personal future. Changing the perspective helps you through a difficult decision.