How the Wealthy Think About Risk

As human beings, we have many innate characteristics etched deep within our minds. Some of these are driven by nature – for example the ‘fight or flight’ response or the need for social interaction. Other characteristics, such as consumerism, are created by society. Either way, they are deeply ingrained, and it requires substantial effort to eliminate them from our personalities.

One such characteristic is loss aversion. Put simply, loss aversion is the idea that humans prefer to avoid a loss over realising a gain of the same size. To quote psychologists Daniel Kahneman and Amos Tversky, ‘losses loom larger than gains’. In practical terms, this means that, when faced with a heads-tails chance of winning £20 or losing £20, most people would prefer not to play. The negative prospect of losing £20 is felt more strongly than the positive prospect of winning £20.

On some level, this loss aversion is understandable. Once we have something, we tend to count on it – it becomes part of our identity. Buddhists would scorn us for this type of behaviour, but it’s the norm in most societies. Losing something we count on is bound to be more negative than the positive surprise from winning something we hadn’t counted on before.

But this mindset can be damaging, especially when it comes to financial decisions.

Too often, we are stymied into inaction because our loss aversion kicks in. That house, those investments in the stock market. What if the value of my investments falls? These thoughts roll into that awful question – ‘what if I fail?’. If you’re asking that question, you’re probably not going to take a chance and you’re probably less likely to succeed.

To better tie together loss aversion with financial investments, we need to explore the concepts of temporary loss and permanent loss.

Temporary Loss

In the context of financial investments, temporary loss represents a loss in value which is recoverable. The value of financial investments goes up and down. This volatility is normal, driven by fluctuations in expectations, the economic cycle and day-to-day news flow. A temporary loss is not existential – you can recover what you have lost over time.

Permanent Loss

Permanent loss, as the name suggests, is an irretrievable loss in the value of an asset. This could either be a 100% loss, or a 50% loss where the 50% lost will never come back.

Let’s make this more concrete.

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Imagine you buy £1,000 of Coca-Cola shares. Suppose the company has some headwinds, perhaps an economic slowdown or an increase in labour costs which reduces its profits. This might lead to the share price falling by 10%, causing a £100 fall in value of your investment. This is volatility. There will be some ups and downs, but over time you would expect Coca-Cola to continue to prosper, by entering new markets, increasing prices and making more profits. Your paper loss of 10% (or £100) is recoverable. It may take time, but it is probably not a permanent loss on your investment.

Imagine another example where your friend is opening a restaurant. You invest £1,000 towards set-up costs, which gives you a small ownership stake. After some initial success, the restaurant starts to lose money and your friend is forced to close the business. As such, the value of your stake goes to zero. Unlike with the Coca-Cola shares, in this case you have permanently lost your £1,000 – the restaurant has gone bust and your money is not recoverable.

This is the difference temporary loss versus permanent loss.

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How does this tie into loss aversion?

Most of us fail to differentiate between temporary loss and permanent loss. Avoiding permanent loss clearly makes sense. But confusing temporary loss with permanent loss can lead to us avoiding risk at all costs. That behaviour can be incredibly damaging; without some degree of risk, we miss out on opportunities along the way.

Some people look at the stock market through the lens of permanent loss. It’s true that you can lose 100% of your money by investing in a company that goes bankrupt. But in a well-diversified portfolio, the companies that do poorly should be offset by those that do well. You may fear a portfolio loss of 30% or more, but the likelihood is that your investment portfolio will recover over time and grow well beyond the money you initially put in.

Over the long run, in fact, your portfolio may end up being many times larger than your original investment. Imagine you were hesitant to invest £10,000 into a diversified stock market portfolio, for fear of a temporary loss of 30-40%. Instead, you choose to keep your money in the bank, earning little to no interest.

By investing in a diversified stock market portfolio over time, say 30 years, your £10,000 would have had a temporary loss of 30-40% on a few occasions. This is natural. There are recessions, periods of inflation, wars and other worries that result in temporary losses. But the losses are temporary, and the value of your investments eventually rebounds. At the end of the period, the £10,000 might have grown to £100,000.

By holding money in your bank account, however, you would still have £10,000 after 30 years. In this example, your fear of a 30-40% temporary loss actually guarantees a loss of 90% against what you could have had – you only have £10,000 rather than £100,000 you could have had (£90,000 less, or 90%).

In order to achieve long-term growth, we need to endure some volatility and temporary losses along the way. This is true both in investments and in life. While they may seem substantial at the time, these temporary losses are merely short-term bumps in the road.

Imagine you were forced to hold onto your investments for 30 years without selling. In that case you wouldn’t care about short-term fluctuations in value. Your only consideration would be the value of the investments after 30 years. A simple re-framing of the picture makes temporary loss seem irrelevant – it’s the end result that counts.

When Loss Aversion Should Help… But Doesn’t

In our investment example, the rational person would see that they could turn £10,000 into £100,000 through investing or maintain their £10,000 by keeping money with the bank. They would see that by keeping money in the bank, there is a permanent loss after 30 years – the £90,000 they could have made but didn’t. This rational person would apply the loss aversion concept to what they could rationally expect to have. Not wanting to waste this opportunity, they avoid the £90,000 loss and invest.

But this is the rational case. Most of us don’t apply loss aversion to what we could have. We apply it to what we do have. This is the problem. We look at the £10,000 and avoid losing that, not at the £100,000 we could have – we don’t seek to avoid the £90,000 loss. Why? Because the extra £90,000 is in the future – it’s not part of our identity today. It might be the path that we’re on, but it doesn’t feel tangible. You can’t see it in your bank account and you can’t spend any of it today. It doesn’t feel real, so it doesn’t feel like a loss.

The loss aversion phenomenon only applies to what we have today, not what we are on track to have in the future.

This is the great irony of misunderstanding different types of loss. By trying to avoid temporary losses, you can end up with a permanent loss. You seek to avoid a £10,000 loss and in the process you rack up a £90,000 loss against what you could have had.

This concept applies in many other parts of life as well. Many of us do it when a new job opportunity comes around. We think about the temporary loss – what if it doesn’t work out? Do we want to give up the salary and reputation we have worked so hard to create? This thinking can protect a small downside, but the permanent loss is not having the career we wanted because we were scared of temporary loss.

You can’t go back to the start of your career – so the opportunities you really wanted are permanently lost, all because you were worried about a few bumps in the road. The end outcome is substantially worse than what it could have been, had you been willing to accept a bit of volatility along the way.

Key Takeaways

Firstly, consider for yourself whether a particular decision will lead to volatility (short-term loss) or true risk (permanent loss).

Secondly, don’t confuse short-term loss and permanent loss. A fall in the value of an investment doesn’t mean you will lose all your money. But nor does it mean that it will inevitably recover. It depends on the investment. A diversified stock market portfolio is unlikely to lose 100% of its value unless it’s actually not diversified, or capitalism breaks down. And it’s likely to recover a 30% or 40% temporary loss over time. But a speculative stock which is down 90% from its highs can easily go bust. Just because it has fallen, doesn’t mean it will inevitably recover.

Thirdly, look at the permanent loss not just against what you have today, but against what you could have in the future. The human bias against loss aversion may mean that you’re quite happy to keep your £10,000 in the bank over thirty years, earning no interest. But you can guarantee that thirty years later you will regret that decision, as inflation erodes the value of that investment over time.

Ultimately, we need to better understand our attitude to loss and how we react to it, to prevent our psychological biases from interfering with rational decision-making. This means spending less time worrying about ‘What if I fail?’ and more time thinking ‘What if I succeed?’.