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Why We Hate Pain More than We Love Gain

 

People don’t like losing money. This much is obvious. What’s interesting, though, is that people suffer much more psychological pain from losing money, than they enjoy pleasure from receiving the same amount.

This is a fundamental concept of prospect theory, developed by Daniel Kahneman and Amos Tversky. Theoretically, a dollar is a dollar is a dollar, and humans should experience the same amount of pain from losing a dollar as pleasure from gaining. But we know from prospect theory that this isn’t the case. Consider critical insurance, like home insurance. Clearly, most people lose money from subscribing to an insurance plan, given that most people’s homes don’t burn down – and that the insurance company has to make a buck as well. However, we realize that in the unlikely, but awful, event of a fire without insurance, most of us would be financially ruined even if no one was injured. So we choose to spend some amount of money regularly in order to prevent us from suffering a horrible financial fate should such a thing come to pass. We are prepared to give up a little bit of gain every year to avoid it.

How does this translate into successful portfolio management? We know that most of our clients are rightly concerned with a permanent loss in their investment capital – the potential of their portfolio to drop 50 to 75 percent or more, with no real ability to recover. Such a situation would be the equivalent of a physical disaster, such as a house burning down, for many people. In our view, this means that we, as portfolio managers, need to reduce the “downside risk” – to create a portfolio that is resilient in the face of market drawdowns and will therefore outperform the overall market in the face of large declines. By investing in blue-chip, dividend-growing companies that make products that people need, we believe we reduce the risk of permanent loss of capital of any one holding, and by diversifying each portfolio through different industries and sectors we reduce the risk of permanent loss of capital of the portfolio overall.

We saw this play out in the market crisis of 2008-09. Most of our client portfolios dropped far less than the major indices; and virtually every client saw their portfolio return to is pre-crisis value within a period of about two years. In other words, in the worst market crisis in 70 years, none of our clients suffered the permanent loss of capital they rightly fear.

In our experience, our portfolios significantly outperform the market in down markets, but underperform somewhat in up markets. We believe this is a fair trade-off. The job of a portfolio manager is not just to make money when everyone else is – it is also (and maybe more so) to protect clients’ investment capital when the going gets rough.

For more on prospect theory, I recommend the excellent Thinking, Fast and Slow, by Daniel Kahneman. Michael Lewis, of Moneyball and The Big Short fame, has also written a book, The Undoing Project, about Kahneman and Tversky, newly released this month.

 

Benjamin Klein, Associate Portfolio Manager

December 12, 2016