How to Fight Your Fear of Losing

Finance's top prize doesn't always go to pure economists...

I'm talking, of course, about the so-called Nobel Prize in Economic Sciences.

I say "so called" because it's a bit of a misnomer. More than 100 years ago, Alfred Nobel left money for five fields of special award recognition... physics, chemistry, medicine, literature, and peace.

Anything outside of these five groups isn't technically a Nobel Prize.

So when you hear about the Nobel Prize in Economics, folks are actually referring to the Sveriges Riksbank Prize in Economic Sciences in memory of Alfred Nobel. It was created six decades after the original five.

As an aside, Nobel's descendants claim that he would never have created a prize in finance or economics. They say he wouldn't have wanted the prize to be associated with money-oriented fields.

Today, I want to talk about a specific recipient of this prestigious award. Daniel Kahneman, who won the Nobel Memorial Prize in Economic Sciences, wasn't an economist at all. He was best known for his work in psychology.

Kahneman's research with psychologist Amos Tversky is rooted in behavioral finance. Said another way, they were interested in the psychological reasons behind what happens in the markets.

(You won't find Tversky's name beside Kahneman's as a prize winner because he died before he could be recognized. Nobel Prizes aren't awarded posthumously.)

And as I'll explain, their work still plays out in real life today...

Tversky and Kahneman found that people's rational thinking could change based on how a situation is framed...

This research was later coined "prospect theory." It describes how people measure gains versus losses differently.

Prospect theory paved the way for a lot of other concepts in behavioral finance, such as loss aversion. That's the idea that folks value perceived losses more than perceived gains, even when the dollar amount is identical.

In other words, it hurts a lot more to lose than it feels good to win.

Many novice investors rely on poor investing strategies. It's one of the biggest gripes among our institutional clients, who are financial advisers themselves. They complain that the investor's biggest dilemma is his own psychology.

Investors tend to sell when the market is low, like it is now... even though the S&P 500 is up roughly 80% since the bottom of the pandemic. The pain of losing 17% overwhelms the good feeling from those longer-term gains.

Kahneman's research touched on many other aspects of behavioral finance...

One of his biggest contributions had to do with "cognitive biases."

I delved into this at length back in June. Cognitive biases are shortcuts that the brain develops when thinking. Unfortunately, they can lead us to make irrational decisions.

Biases are a key reason folks make so many mistakes when investing. It's not entirely our fault, either. The mainstream media is great at sensationalizing everything for views. That helps everyday investors make more – and worse – mistakes.

He and Tversky also discussed what's called the "availability heuristic." When making decisions, we tend to use information that comes to mind quickly. We rely on and regurgitate the most immediate examples... even if they're not the best.

And if that information is coming from an untrustworthy source, it's even worse. People will use that bad data to make bad decisions.

You can see this play out all over the markets. Wall Street continues to use generally accepted accounting principles ("GAAP") to forecast performance and generate valuations. Many folks know this data isn't reliable. They use it because it's readily available.

It's easier to use GAAP data than it is to argue about what companies are required to report in their financial statements. That's just too much effort.

Meanwhile, many headlines claim that China's economy is overtaking the U.S. It's hard not to take those opinions seriously – even though they're also based on faulty as-reported GAAP and Chinese Accounting Standards data.

These headlines often come from mainstream media sources like Fortune magazine... which Americans believe to be unbiased.

You probably didn't know that Fortune magazine was purchased by one of Asia's richest families in 2018. The family owns a conglomerate of more than 200 subsidiaries around the world... including in mainland China. So take its coverage with a grain of salt.

In the past, I've hosted Altimetry subscriber-only seminars discussing the U.S., China, and global economic power. If you'd be interested in attending a future session, send me an e-mail at [email protected]. We'll send you an invitation when we finalize the details.

While you can't escape these biases completely, you can fight them...

It starts by having better perspectives and gaining more accurate information. Not everyone publishing news has your best interests in mind. Some stories are only out there to attract your attention.

By avoiding this misleading information, you set yourself up to make better decisions as an investor.

It's also important to fight cognitive biases, which can hurt your performance. The best way to do this is to be aware these biases exist. Then you can look out for them in your own analysis.

If you see that the current market is down 20%, you might be more likely to sell... when you really should be starting to buy back in.

However, if you remember that humans are naturally inclined toward loss aversion, you'll be able to think through the situation more rationally.

Yes, the market is down this year. Even so, it's not all doom and gloom. If you bought in before the pandemic or at nearly any point in 2020, you're likely still in the green. That can help ease the pain of perceived loss.

And remember, like Kahneman and Tversky, many of the greatest insights don't come from mainstream experts. Consider the motives behind the opinions you hear. And count Wall Street and the media as two sources to be wary of.

Wishing you love, joy, and peace,

Joel
December 16, 2022