You might think that as a country's economy recovers from a downturn, the wellbeing of its people also rises. But even years after the 2007 recession, people in Greece remained less happy, as the BBC reported as late as 2015.
An economic crash can obviously heighten people's feelings of uncertainty and pessimism about the future, and this can affect wellbeing for a long time afterwards. It can make people more cautious: for example, choosing safer investments to avoid the pain of a financial loss even if they can afford to take more risk.
It can make sense to factor in the emotional effects of economic fluctuations when planning investments.
Which would you choose?
Nobel laureate Daniel Kahneman and his long-time collaborator Amos Tversky, in their seminal 1979 paper Prospect Theory, suggest people are more likely to act to avoid losing money than take the risk of winning an equivalent amount, depending on their individual, starting reference point – a phenomenon now known as loss aversion.
In a series of experiments, Kahneman and Tversky asked people questions such as: "Imagine you had £1,000 to invest: would you prefer option A or B?"
A) A fund with a 85% chance of growing your money to £1,500 and a 15% chance of it falling to £500
B) A fund with a 100% chance of growing your money to £1,100
How would you answer? Your starting point will typically affect your appetite for risk, and therefore your choice of answer to the above question. In this case, many people will prefer the sure bet.
Since 1979, others have examined how loss aversion might have real-world consequences for wellbeing. A 2013 paper by Christopher Boyce and colleagues used data from Germany and the UK to measure whether income gains and losses had different effects on the wellbeing of almost 50,000 people. The authors found that although a rise in the average person’s income is associated with higher subsequent wellbeing, an income loss of similar size predicts a fall in life satisfaction which is twice as large.
“Wellbeing penalty” of recessions
Loss aversion was examined on an even grander scale in an October 2014 paper by London School of Economics’ Jan-Emmanuel De Neve and colleagues. Using data on over four million respondents across 151 countries over four decades, the authors found that economic contractions (such as recessions) make people much more unhappy than economic growth makes them happy.
They wrote that the effect was consistent and very large – and calculated that the “wellbeing penalty” of a two or three percent decline in GDP could be two to four times the wellbeing gain of a two or three percent increase. They gave the Greek example cited earlier, highlighting the strengths of a “slow and steady” sustainable growth rate over a boom-and-bust economic cycle, such as seen several times over the past century.
Managing investment risk should include emotions
It appears that loss aversion can play out in a big way during recessions and have an impact on many lives. It suggests that a preference for avoiding losses can be well founded, given the damage an economic loss can inflict not only to an individual’s wallet but also his or her wellbeing. It is therefore important for investors to bear loss aversion in mind.
Whether you chose A or B in the example above, there is no one answer that is correct for everyone. If you weighed up the risks and went for the greater gains being offered in A, that’s fine, but remember to price in the emotional risk of a loss, not just the financial risk.
The choice also needs to be weighed against the comparatively mild increase in happiness that may result from seeing the investment rise in value. For long-term share investors, a strategy could be to not pay much attention to short-run fluctuations in prices – the dips will probably hurt more than the rises will make you happy.