Blogs | January 11, 2012

Lost money? You should forget about it

It can pay to look back to see if losses alter the way you manage money.

There is evidence investors react to losses by taking more risk. And in that sense, people can behave like rogue traders.

The rogue inside
By this, I don’t mean that we defraud our employers of billions of pounds, like some high profile rogue traders. Instead, I mean that what rogue traders do in an extreme form what many of us do in a milder one. Rogue traders do not, usually, lose hundred of millions pounds suddenly. Instead, they start by making a small loss and then, in an effort to recoup that loss take bigger gambles. Sometimes, those gambles succeed, and the trader keeps his job and his anonymity. Occasionally, though, they fail spectacularly, and he becomes as notorious as former traders Jerome Kerviel and Nick Leeson.

However, the habit of chasing losses is quite common, as many who have visited a casino or racecourse will know. Academics Richard Thaler and Eric Johnson called it the “break even effect”; people take gambles they would otherwise avoid in an effort to recoup losses. Daniel Kahneman and Amos Tversky showed how powerful this effect is when they offered people a (hypothetical) choice between losing $3000 for sure or taking an 80% chance of losing $4000. 

They found 92% would rather gamble, even though the expected value of doing so is worse than $3000 (in mathematical terms 0.8 x 4000 = 3200). Of course, this might show merely that people like to gamble. But it doesn’t. When faced with a choice of a certain gain of $3000 and an 80 per cent chance of winning $4000, the overwhelming majority chose the safe option.

It’s official – losing money hurts
Neuroscience can explain what’s happening here. Camelia Kuhnen and Brian Knutson, two researchers at Stanford University, wired people up to fMRI scanners and asked them to make some investment decisions. They found that when people thought about profits, there was high activity in the nucleus accumbens, part of the brain associated with pleasure and reward. But when people considered the possibility of loss, a different part was stimulated – the anterior insular, which is associated with pain and disgust. 

They inferred that “risk seeking choices and risk averse choices may be driven by two distinct neural circuits”.

In other words, losses are not simply profits with a negative sign, as accountants and economists say. The brain processes them differently. It’s no wonder, then, that we behave differently when faced with losses than profits. Just as we go to great expense to avoid pain – look at the size of the market for quack medicines – so we also do so in an effort to avoid losses.

Why we back outsiders
In gambling, this can lead to the favourite-longshot bias; people lose money even more quickly if they back outsiders than they do if they back favourites. One reason for this is that long-odds bets are seen as a quick way to recoup past losses – which they are not.

And find it hard to sell falling shares and property
In the stock market, it leads to the disposition effect – the tendency to hold onto poorly performing stocks in the hope that they’ll return to the level we bought them at. Such behaviour is, however, collectively self-defeating. Because investors don’t sell shares as much as they should, their prices don’t immediately fall as much as they should.

Instead, they gradually drift down as investors eventually do throw in the towel, which imposes further losses onto those who have clung on in the hope of breaking even. There is momentum in share prices.

It also has effects in the housing market. Because people are loath to sell their homes at a loss, they tend not to put them onto the market in bad times unless they are desperate. This means that house prices tend to fall only gradually, because a lack of supply cushions their fall. This is not good. It means that corrections to house prices take many years, during which time some people are stuck in houses they would rather not live in whilst others are unable to afford to buy.

Just forget about it?
Luckily, there is, in principle, a simple solution to these thinking traps that can come in to play with finances. We should recognise that past losses – on horses, houses or shares – can be considered irrelevant. What matters more are prospective gains and losses, not past ones.

Sadly, though, knowing this and acting on it are two very different things.

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Chris Dillow
Chris Dillow

Investors Chronicle writer and economist