Loss Aversion and The Beast Within

The Beast Within - with Nightcafe AI

Daniel Kahneman passed this week.  In 2002, he won the Nobel Memorial Prize in Economic Sciences, for his work on how we take decisions. His book, Thinking, Fast and Slow, made behavioural economics accessible to a wide range of general readers, and is a work I would like to re-read at least once in every one of the few decades left to me.

Economics, as we were taught in the 70s, was based on the notion that man is a rational being, and though it was apparent even to a half-witted undergrad like me that this was only a convenient assumption, rather than a credo to which you had to swear eternal allegiance, the work of Kahneman and others explored the world outside of rationality, the heuristics and biases to which humans are suspect.

This is a rich field for an investor, and as I wrote on a school group yesterday:

Evaluating companies is tough, but only table-stakes - if you can’t do that, you shouldn’t be an investor. The tougher part is managing your emotions and your biases, and there, the work of behavioural economists is invaluable.

The one insight from this body of work that helps me think more clearly about my work is the concept of loss aversion - that losing a hundred rupees has a greater emotional impact on humans than winning a hundred, roughly twice as much.  The fear of losing money in ‘risky’ investments - like equities - prevents many people from investing in the stock market in the first place.

But when they do make that leap, and face their first loss, then matters get really interesting. Now, you have to throw in two other concepts from economics: the endowment effect, and the anchoring effect. The endowment effect, briefly, means that you tend to place a higher value on what you own than the market does. So, you believe that the market is not putting the right value on your share, which you bought at a higher price.

You believe that the ‘right’ price of the share is the price at which you bought it - your valuation of the share gets ‘anchored’ to the price you paid for it. 

And, going back to loss aversion, as long as you don’t sell the share, you can continue to kid yourself that the loss is notional:

“This is not a loss, just a downturn in the price: loss is real only if I actually sell it.” 

Rather than dealing with the reality of that loss, you postpone the decision - which comes from the interplay of these three irrational phenomena - the anchor of the price you paid, the attachment you have to owning the share, and the aversion to accepting the loss. These biases have a real cost at all times, but when markets see a phase shift, from a bull run to a bear hug, the cost of inertia is huge.

In my experience, you’re never going to completely rid yourself of these irrationalities. But you have to learn to distance yourself from them. One way is to set up cold, number-based decision rules for exiting bad buys - 

“If a stock drops 20%, sell it.” 

Remember, you can always buy back the share, but that’s better done after you’ve re-examined the business,  questioned your assumptions, and reinforced your conviction for investing in it. By postponing your exit, you’re running the risk of seeing your investment erode further. The extent of this loss is not known in advance, but what is known is that the money blocked in that share could be used to earn money elsewhere - in another share, or even in a bank deposit - the so-called ‘Opportunity Cost’ of money.

The other thing I do to reduce my likelihood of behavioural mistakes is to confront my mistakes - several times a year, I’ll go back to the investments that lost me money, and stare at the losses. It’s like looking at yourself in the mirror, and reminding yourself how stupid you were  - 

“Why didn’t you exit when Paytm dropped 20%? Why did you wait for it to halve?”

The fact that I misread the business, or its operating environment, is bad enough, but much of my loss could have been averted by a rule-based exit, which avoids the minefield of emotions that govern so much of our behaviour. But behavioural economics has a lot to say about the stock-selection process, too. We tend to take unconscious decisions fairly early in the process (the ‘Fast’ thinking). After that, we tend to welcome inputs that tell us we were right, and reject those that tell us we were wrong - our decision-making is skewed by the ‘Çonfirmation’ bias. 

A rational process requires us to ‘Slow’ down our thinking, postpone the decision. Once again,  to confront the illogical, irrational being in the mirror. It’s really tough, and intellectual rigour would require you to argue both sides of the trade. Large investment firms have more resources to do this than do individual investors; but it’s more about dealing with the nature of the beast within, than about wielding the tools without.

A life without reading is unimaginable for me. The wealth of books is not to be measured in gold. For behavioural economics, though, I would go full-throttle Philistine and say - well-learned, these lessons are worth millions of dollars.

Your insights will live long, Daniel Kahneman.