Tuesday, 18 March 2014 - 20:00

 

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Seed Weekly - Loss Aversion: Why it?s Rational

Standard economic theory suggests that a rational investor will feel an equal amount of pleasure for every 1 unit of gain on an investment portfolio as they would pain for every 1 unit of loss. Research has shown, however, that losses are psychologically twice as powerful as gains, with the first proponents of this behavioural trait being Messrs Tversky and Kahneman.

Chart 1 below illustrates the emotions that one should feel in theory (in black) versus the observed emotions (blue) of investors making losses and gains.

Chart 1: Pleasure vs Pain

Should one treat losses the same as gains?

I would argue that loss aversion occurring naturally is actually rational behaviour in the case of investing.

It all comes down to the mathematics involved in recouping losses – investors require more than 1% in gains for every 1% lost in order to get back to the original (breakeven) position. This also helps to explain why most successful investors place a heavy premium on avoiding permanent capital destruction. There isn’t much difference for the first 10% – 20% of losses, but thereafter the difference between the loss made and the gains required increases exponentially. Chart 2 below graphs the required gains for each increment of loss on an investment portfolio.

Chart 2: Loss v Required Gains

The required gain illustrated in Chart 2 more closely mirrors the emotions of the pain felt in Chart 1 than the theoretical position based on the assumption that gains and losses are felt equally.

At a 10% loss, you require an 11% gain to get back to your starting point, at a 20% loss the gain required increases to 25%, at 50% you need to double your return, while a 67% loss requires your investment to triple before recouping all your losses. It is evident that there isn’t too much difference up to the 20% drawdown level, but from these levels it becomes increasingly difficult to rapidly recoup your losses.

As a result of this phenomenon, Seed has designed solutions to avoid deep drawdowns as far as possible. All investors need to take an element of risk in order to ensure that your portfolios grow sufficiently to cover your retirement needs. It is important, though, to manage the amount of risk you are exposed to and mitigate portfolio risk by combining uncorrelated growth assets within your portfolio. Small drawdowns will naturally be unavoidable, but permanent destruction of capital is to be avoided at all costs.

The Seed Flexible and Seed Absolute Return Funds both combine asset classes and strategies in order to generate inflation beating returns while minimising the probability of large capital drawdowns.

Take care,

Mike Browne

www.seedinvestments.co.za
info@seedinvestments.co.za
021 914 4966

Tue, 18 Mar 2014

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