Are we Loss averse or Variance averse?

How many times you have compromised on return and invested in a relatively safer instrument; or fretting about the potential loss before making an investment, or worst sold the investment whenever there was the slightest dip in the value of the portfolio. This impulse to protect you is called the safety first principle or “loss aversion.”

The influence of emotions on decision-making is widely accepted. Neurophysiology evidence suggests that loss aversion has its origins in relatively ancient neural circuitry (e.g., ventral striatum). This evidence also helps us to understand while modern finance theories tend to see risk as related to variance in expected returns; the psychology literature tends to link risk to probability or size of potential losses.

The assumption of modern portfolio theory about the efficiency of market and rationality of investor is long been nullified. Individuals do not tend to act rationally when making decisions in a risky environment. Most of the times individuals have little information, process such information using simplified routine, and are influenced by the way in which information are presented to make a decision.

Before the advent of Modern Portfolio theory (MPT), the investment risk is measured in terms of absolute loss or relative loss vis-à-vis of a market index. Variance as a measure of Risk was first introduced by Economist Harry Markowitz in MPT in a 1952 essay, for which he was later awarded a Nobel Prize in economics. This idea of variance as a measure of Risk is so new that it never percolated in the psyche of investors, despite the fact that all the subsequent development in Risk Management – Risk-adjusted return, Value at Risk, EWMA, Downside Deviation or GARCH – uses variance as a building block.

The significance of standard deviation (the square root of variance) can be gauged by the fact that 68.2% of the time your return of the investment will lie between one standard deviation above and one standard deviation below the mean value, 95.4% of the time your return of the investment will lie between ‘2’ standard deviation above and ‘2’ standard deviation below the mean value and 99.7% of the time your return of the investment will lie between ‘3’ standard deviation above and ‘3’ standard deviation below the mean value.

We don’t have empirical evidence to conclude whether individuals are loss averse or variance averse but our experience in the field of investment suggest that individual is more loss averse than variance averse.

Dan Ariely, James B. Duke Professor of Psychology and Behavioural Economics at Duke University, and the author of ‘Predictably Irrational’ and ‘The Upside of Irrationality’, both of which became New York Times bestsellers opined that “People hate losing much more than they enjoy winning. How happy are investors when they make 3% on their investments and how miserable are they when they lose 3%? There is a tremendous asymmetry.”

The asymmetrical behaviour of the individual under the fear of losing money tends to make these common mistakes:

First, they ‘overweight’ the lesser probability and ‘underweight’ the higher probability and sometimes totally ignore a minor event.  Their response to a loss is more extreme than the response to a gain of the same magnitude. Instead of cutting loss, they try to recoup the loss by liquidating their profitable assets—that could run counter to their long-term investment goals.

Secondly, they often increase their risk-taking in order to try to escape losses and fall victim to the sunk-cost fallacy. The sunk-cost fallacy is behaving as if more investment alters your odds, believing the more you put in, the more it will pay off.

Third, they fail to distinguish between a bad decision and a bad outcome. Individual regrets bad outcome of a good company like a weak quarterly result or low returns over a period, even if they have chosen the investment for all the right reason. In such case, regret can lead them to make a decision to sell. This means selling at the bottom instead of buying more.

Lastly, they justify holding the safe investment by comparing the alternatives with respect to a specific point of time, that is, they always evoke Internet bubble of 2000 or Lehman Brothers collapse of 2007 to justify not investing in stocks – thus losing the chance of potential return.

It is interesting to note investors – amateurs and professionals alike, regardless of intelligence or skill level – act intuitively under risky and uncertain condition forgetting that today’s uncertainty won’t likely last forever.

Risk aversion is important. This is natural check and balance – keep us away from financial fraud and also keeps our expenses in control, and helps us to save for a rainy day. But loss aversion is short-sightedness. It happens when we lose sight of our long-term goals, and focus too much on short-term events.