Would you take this Bet?
Recently, I was restructuring my stock portfolio as the US stock market has come down about 20%. As signs of recessions are on the horizon, I took a risk-off approach with my portfolio by keeping more cash and selling most of the growth stocks. During this exercise, it was painful to cut losses from some of the investments that were performing poorly. In my mind, I was thinking, what if the market rebounded and things got better? During my dilemma, I found a video titled “Would you take this bet?” that helped me better understand what I was going through emotionally.
In the clip, the host asks a few random people if they would take a coin toss bet. You know the typical heads/tail coin toss game. If they win, they will get $10, if they lose, they need to give the host $10. Even though the odds are 50/50, most people said they wouldn’t take the bet. Well, that makes sense cause there is no real value.
Next, the host offered to increase the prize money to $20. If a participant wins, they will get $20, but if they lose, they need to give the host $10. Even though they stand to gain more than they would lose, most people dislike this gamble because losses loom larger than gains.
We feel losses more than we feel gains. This scenario was described by Dr Kaneman in his book Think Slow and Fast. Dr Kahneman discusses why losing money hurts more than making it, a concept called “loss aversion.”
The host goes on to offer another bet. A 100 bet of winning $20 when right and losing $10 when wrong. Would you take this bet? Again most people won’t even though, at the end of the bet, you will win. Here is the breakdown. The probability of winning is 50/50.
Therefore the expected return will be :
50 chance of getting $20 = $1000
50 chance of losing $10 = -$500
Total = $500 gain, and if you are so unlucky, there is only a 1 in 2300 chance of losing money.
Dr Kahneman further explains that there is an asymmetry between threats and opportunities. When we have suffered a series of losses, we tend not to make any more future investments. The asymmetry we feel is probably an evolutionary trait. There is an asymmetry between pain and pleasure, and in general, a pain signal is a more urgent signal than pleasure. They both are signals, but one is more urgent than the other.
In an investment scenario, what motivates investors? If you answered “gains,” you’re only partially correct. As it turns out, people tend to hate losses more than they like gains. This basic principle of human psychology sums up “loss aversion.”
Loss aversion also explains some investors’ behaviour: people are more likely to sell stocks that have gained money than stocks that have lost money because they consider the buying price a reference point.
People don’t like to have losses in their portfolios. This is very similar to what some of my clients did during the past few months when their account was red. They preferred capitalising on their losses against my advice than seeing their account in the red. Cutting off good stock holdings in a market downtrend is contrary to the primary consideration when buying stocks, which is to consider how well a stock might do in the future, not its previous value.
This experiment demonstrates how we might miss out on great opportunities when we don’t take enough investment risks. At the same time, to feel safer about the risk in investments, we should look at our investments as a series of investments over the long term instead of looking at an investment in a short-term view. You may win some and lose some in the short term but come out winning in the end.