Fear of losses vs ecstasy of gains

IN the world of investing, emotions play a crucial role in decision-making processes. Two of the most powerful emotions investors experience are the fear of losses and the joy of gains. Understanding how these emotions influence investor behaviour is essential for making informed investment decisions. The interplay between the fear of losing money and the exhilaration of making a profit can significantly impact an investor’s portfolio.

The fear of losses, or loss aversion, is a principle in behavioural economics stating that the pain of losing is psychologically about twice as powerful as the pleasure of gaining. This concept was popularised by Daniel Kahneman and Amos Tversky in their Prospect Theory. According to their findings, losing $100 feels much worse than the joy derived from gaining $100.

In practical investing terms, this means investors might irrationally hold on to losing stocks for too long, hoping they will rebound, rather than accepting the loss and moving their investments into more promising assets. This behaviour can lead to missed opportunities and greater losses over time.

Moreover, the fear of loss can cause investors to be overly conservative, potentially foregoing higher returns from investments that, while more volatile (‘riskier’), might be appropriate for their long-term objectives.

For instance, younger investors with a long investment horizon might benefit from a portfolio overweight with equities, which, although volatile, generally offer higher returns over the long term compared to bonds or cash. However, the fear of shortterm losses might drive them to opt for less volatile investments, potentially compromising their future financial security.

On the flip side, the joy of gains can be equally influential, albeit often less detrimental, when managed properly. The pleasure derived from seeing investments grow can reinforce positive investing behaviours, such as staying invested during market upswings or systematically investing through rand-cost averaging.

However, the euphoria associated with gains can also lead to overconfidence. Investors may become overly optimistic about their investment picks, ability, and market outlook, potentially underestimating risks and overestimating returns.

This overconfidence can manifest in several risky behaviours. For example, investors experiencing significant gains might be tempted to allocate disproportionately to a single share, asset class or sector, believing their past success will continue unabated. This lack of diversification can increase the risk significantly if that particular asset underperforms.

Additionally, the joy of gains might prompt some investors to trade too frequently, chasing performance and incurring higher transaction fees and taxes, which can erode returns.

Balancing these two emotions – fear of losses and joy of gains – is crucial for successful investing. One effective strategy is adhering to a disciplined investment strategy or plan that includes regular reviews and rebalancing. This approach helps mitigate the emotional impact of market fluctuations, allowing investors to make adjustments based on rational assessments rather than emotional responses. Furthermore, understanding personal risk tolerance and investment horizon can guide asset allocation decisions, helping investors maintain a balanced perspective in the face of gains and losses.

Ultimately, successful investing requires not just financial acumen but also emotional intelligence.

Recognising the powerful influence of fear and joy and implementing strategies to manage these emotions can help investors avoid common pitfalls and achieve their financial goals more reliably and consistently. Embracing a mindset that appreciates the slow and steady accumulation of gains while judiciously managing the inevitable losses can lead to a more satisfying and potentially more profitable investing experience. − Moneyweb