To Be a Great Investor, You Must Be a Smart Loser
How you deal with investment losses will determine your future returns
Investment losses, are an unfortunate—but certain—reality for long term investors.
Endless amounts of time, energy and money are scarified to futile efforts to avoid financial losses.
Much less thought is put into a more useful pursuit—Preventing financial losses from causing you to make fear-based decisions that will prevent you from accumulating more wealth in the future.
How do people respond to financial losses?…with fear
A 2022 paper , titled "How Do Humans Respond to Huge Financial Losses?", explores how people react after experiencing massive financial losses.
The researchers wanted to know if a big financial hit makes us want to protect what we have left or if it makes us take even bigger risks in an attempt to recover what we lost.
To explore this, the researchers used data from a British TV game show called "The £100k Drop." On this show, participants are given £100,000 and have to answer a series of questions, placing their money on what they think is the correct answer. If they get it wrong, they lose the money placed on the incorrect answers.
This setup provided a unique opportunity to observe how people handle large sums of money and what happens to their decision-making process after they lose a significant portion of it.
The researchers tracked how participants spread their remaining money across the possible answers after each loss.
They measured this using what they called a "diversification index," which basically shows how much people were trying to minimize their risk by spreading their money out.
By analyzing these behaviors, the researchers could see how a loss in one round influenced the participants’ decisions in the next round. This gave them insights into whether people became more risk-averse (i.e., cautious) or more risk-seeking after losing money.
A quick note about diversification before we discuss the results
As investors, there are two primary forms of diversification:
Within an asset class (do I invest in a handful of individual stocks, or buy the whole market using an index fund)
Among different asset classes (do I invest 100% in stocks or do I invest in both stocks and bonds)
It’s important you keep these two separate forms of diversification in your head as we discuss the results of this research paper.
Learn the right lessons from losing money
The researchers found that people generally become more risk-averse after experiencing significant financial losses.
After losing a substantial amount of money, participants in the game show were more likely to spread their remaining money across multiple answers in the following rounds, rather than risking it all on one answer. For example, losing £10,000 increased their likelihood of diversifying their investments by about 6 percentage points. This cautious behavior was even more pronounced when the losses were larger in proportion to their remaining money. If participants lost 50% or more of their cash, their propensity to diversify increased by about 13 percentage points.
These results suggest that big financial hits can make people more wary of taking risks, which is an important insight for investors.
But, it’s important to understand that not all risks are created equal. Here are two points to consider
Point 1: Reducing risk by diversifying within an asset class is almost always a good idea.
If you invest half your net worth in an individual stock and that company goes bankrupt, you’ll be much more likely to embrace diversification within your stock holdings in the future.
Rather than investing in individual companies, you’ll be more likely to eliminate the risk that any one company goes bankrupt by investing in every company through a low-cost index fund.
I have literally written an entire book on why this is a smarter way to invest in the stock market.
Point 2: Reducing risk by diversifying among different asset classes is more complicated
When it comes to expected future investment returns, risk and return are inseparable.
If you want to increase your expected returns, you’ll need to increase more in risky assets like stocks and less in safer assets like bonds.
If your reaction to making a bad investment is to permanently reduce your exposure to risky investments likes stocks, you shouldn’t expect to earn much return on investment in the future.
That’s not to say, you shouldn’t diversify between different assets like stocks and bonds—but don’t let fear drive your asset allocation.
Wait for your emotions to stabilize before making major changes to your portfolio.
Patience, and emotional resilience and essential attributes of a successful long-term investor.
Want to share your experience with emotional investment decisions?
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.