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By Guest Blogger Doug Rowat
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We’ve all made bad investments. We can recognize this as a normal part of the process, likely to be more than offset over time by our other, better investments, and simply move on.
Or we can go other routes.
One route, of course, is to become so traumatized by the poor outcome that future risk-taking is curtailed. Occasionally, we may even become conservative in the extreme. MIT’s 2022 study of panic selling, for instance, showed that once investors panic sold and locked in their losses 31% of them never returned to the market. Ever.
But there’s another, equally destructive route that money-losing investors often take: the route of mindlessly excessive risk-taking designed to erase those losses as quickly as possible. In poker, this is called playing ‘on tilt’. Here’s a good example:
However, before discussing on-tilt investing, let me briefly highlight where all this poor investing behaviour comes from in the first place: loss aversion.
We had a client recently who requested a y-t-d performance breakdown of each and every one of their ETF holdings. Despite the spectre of a global trade war, the threat of rising inflation and a deteriorating corporate earnings outlook, our client portfolios have actually performed well this year. However, as you can imagine, the client focused not on the overwhelming number of positions that were positive (many with double-digit gains) but on the few positions that were negative.
Are these positions cause for concern over the long term in an otherwise well-diversified portfolio? Of course not. But this is how loss aversion always works. Losses occupy far more of our attention and energy than they should and certainly command far more of our focus than the wins.
So, it’s this strong desire to wipe away the emotional discomfort of a loss that often drives us to subsequently take abnormally high levels of risk. But this, of course, is a doomed strategy.
First, here’s proof that we’re susceptible to transitioning from loss aversion to excessive risk-taking.
In the 1970s, Mukhtar Ali, an economics professor at the University of Kentucky, looked at the results of more than 20,000 harness horse races and noted that bettors take bigger risks during the later races as their capital dwindles. In other words, when the odds still suggest prudently betting on the favourites to make modest gains, bettors were instead, to their detriment, favouring the longshots in order to win their money back fast. ?
But this strategy is doomed because of the mathematics of losses. The more you lose, the greater the gains that are required to breakeven—exponentially so. If you lose 10% of a $1,000 investment, you now need an 11% gain to breakeven. Not ideal, but not catastrophically long odds of a recovery. However, the chances of breakeven massively diminish as the loss percentage amplifies. An 80% loss on $1,000 now requires a 400% gain to breakeven. A 90% loss, a 900% gain! This leads, of course, to investors behaving recklessly and attempting to ‘swing for the fences’ to eliminate the loss. Like the poker player in the above example, investors may, figuratively speaking, resort to pushing all-in without even bothering to look at their hold cards.
Laws of recovery
Source: Fraim Cawley & Company
So, losses suck. But they happen to the best of us. Giving up and abandoning the market entirely isn’t the solution. But neither is attempting a moonshot.
Never play the game on tilt. Be patient. Play to win.
Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.