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Why does the pain of market loss feel so much stronger than the joy of market gains?

Why does research show losing $1 feels worse than being given $2? Behaviorist Dr. Meir Statman explains the science behind why the sting of losses—in the market or in our lives—often outweighs the joy of gains.

Transcript

Tim Maurer:
Hello, and thank you for tuning in to Ask Buckingham, an ongoing video podcast series where we invite thought leaders across many disciplines in wealth management to respond to your timely questions with timeless answers. My name is Tim Maurer and I have the privilege of hosting these short discussions as the director of Advisor Development for Buckingham Wealth Partners. I want you to know that I’m also a wealth advisor with more than 20 years of experience and a client of the firm.

Tim Maurer:
The volume of information coming at us these days is so vast, and the pace at which that information arrives is so fast that it’s often a struggle to keep up with what you need to know in order to make the best decisions for you and your family. Our hope, therefore, is that this ongoing conversation will become a source of clarity in the midst of confusion and provide insight that helps you better understand what’s going on in the world, financially and otherwise. Today we’ll be hearing from Dr. Meir Statman, a consultant of Buckingham and the Glenn Klimek Professor at finance at Santa Clara University, and one of the world’s foremost authorities in the field of behavioral finance. Here’s the question we’ll be tackling today. Dr. Staman, the word volatility actually applies both to rapid downward movements in the market as well as positive market gains, so why does the pain of market losses feel so much stronger than the joy of those gains?

Dr. Meir Statman:
Well, first people talk about volatility, but what they are talking about is losses. Nobody alarmed, chagrined when market goes up. Now, losses are painful. Here’s an experiment I’ve conducted, in fact, in many countries. Think about it this way, imagine that I’m going to be tossing a coin, if the coin comes out heads, your portfolio is going to grow at the rate that will give you a 50% increase in your standard of living. You’ll be able to do stuff that you cannot do now.

Tim Maurer:
How about that.

Dr. Meir Statman:
From now on, you’ll fly first-class.

Tim Maurer:
Okay.

Dr. Meir Statman
But if it comes out tails you are going to lose some X percent of your standard of living. What percentage X are you willing to commit to on the downside before I flip that coin?

Tim Maurer:
Well, Dr. Statman, I can tell you right now that I better talk to my wife first if I’m going to answer that question.

Dr. Meir Statman:
Well yes, but also ask yourself before you ask your wife. Your wife might be more daring than you are.

Tim Maurer:
You never know.

Dr. Meir Statman:
And so when I asked Americans, the average of that X was 12,5%. In other words, people are willing to give up 12.5% of their standard of living for a chance, an equal chance, at a 50% increase. Now, the ratio of 12,5% to 50% is four, and so people want four times as much on the upside to compensate for one on the downside. That is loss aversion. And that loss aversion is not an error at all, it is natural and it is wise. Because when I think about a 50% increase in my standard of living, yes, I can perhaps move to a bigger or nicer house. Yes, maybe I can fly first class. But a decline of 12,5% is really very painful, more painful than the prospect of an increase in the standard of living.

Tim Maurer:
Of course.

Dr. Meir Statman:
It is fine to be loss adverse. Of course, loss aversion, like everything else, can be exaggerated. And so we have to be careful and think about it carefully before we commit.

Tim Maurer:
Now Dr. Statman, could we take this to some level of application in how we build our portfolios? Are you suggesting that we should pay more attention to those conservative or more stable elements in our portfolios, like short term bonds?

Dr. Meir Statman:
No, I don’t think so. I think that we should strike a balance between two wants. I say, with obvious exaggeration, that we want two things in life. One is to be rich and the other is not to be poor. Each of us strikes a balance, a different balance, between those two wants. And so some people, for example, leave employment as an engineer to start a startup in their garage, maybe taking a second mortgage on their house. That works for them because they want to be rich. When I say rich, I don’t mean a billionaire, I’m meaning something that is more than they have now. Other people say, “Being an engineer employed at Google or elsewhere, that’s pretty good for me. That is fine.” You have to really calibrate where you stand on that and you have to build a portfolio accordingly. And so if you are young and you have a lot of what we call human capital, income that you’re likely to earn during your working years, then you can take more risk in your portfolios and have more in stocks there. If you are nearing retirement, of course your human capital is lower and you better take a portfolio that is more conservative, that has more bonds in it.

Tim Maurer:
Absolutely. Now you’re, I’m sure, aware of the fact that when people put portfolios together, there are many different types of questionnaires out there. There are always hypothetical questions like, if your portfolio dropped 30%, what would you do? Are there inherent challenges in those types of questionnaires because the hypothetical challenge feels so much different than the actual challenge that people are going through at a time like this?

Dr. Meir Statman:
Yes. Yes. This question of, what will you do when the market goes down 30%? When you think about it, say, a month or two ago seemed like, “Ah, that’s no big deal. I’ll be able to weather it, I will do nothing.” But when you are in it, it is really very different and very difficult. I mean think about a horror movie. You sit there at the edge of your seat, you are afraid, but then when you go out and the light is on and you say, “Huh, that was fun.”

Dr. Meir Statman:
And so actually a better question to ask is, what do you think the market is going now… or rather going in the future? If the answer is, “Everything is going to be perfectly fine. There’s going to be high returns with low risk.” This is the mark of exuberance. If you say, “Everything is going to be bad, high risk and low returns.” That is probably fear and perhaps even panic. And so don’t put yourself in a hypothetical situation where it is easy to answer. Think about it in terms of how do you feel now if that’s what will happen in the future.

Tim Maurer:
It’s all about balance, Dr. Statman. Thank you so much and thank you for tuning into this episode of Ask Buckingham. If you have a question that you’d like to see us address, you can do so by navigating to the website, askbuckingham.com or emailing your question to question@askbuckingham.com. Remember, there are no dumb questions, but unfortunately there are plenty of poor answers out there. Our hope is that in giving you straight answers to your questions, you’ll be able to apply that knowledge in pursuit of good decision making. So, please follow us, and by all means, ask Buckingham.

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