On CNBC’s “Squawk on the Street” show today they discussed investors’ short-term memory and how it can trip them up. It was a good show in explaining how investors feel about the pain and pleasure associated with losses and gains in their portfolios. I’d like to add and explain the dynamics of facing a likely gain vs. a sure loss.
The theory known as "Prospect Theory", originally described by Daniel Kahneman and Amos Tversky, says that individuals are much more upset by prospective losses than they are pleased by equivalent gains. Therefore, the loss of $100.00 would be twice as painful as the pleasure received from a $100.00 gain.
In my work with both consumers and financial advisers, I've found that people are willing to take more risk to avoid losses than to realize gains. In other words, when faced with a likely gain, investors are more likely to be risk-averse, while when faced with sure loss, they turn into risk takers. You can see how this pattern could affect average investors. It's a spiraling effect with one bad investment decision threatening them with a sure loss, which will lead them to take more risks in order to avoid this loss.
I’ve seen this theory in action with some of my private clients in the last six months. Their worry about loss had become unmanageable and they no longer felt in control. All they wanted to do was sell and stop their losses. If they had sold, their timing would have been impeccable being right at the bottom.