“Everyone has a plan until they get punched in the face”  – Mike Tyson

When I saw the above quote somewhere, I really laughed and I wrote it down!   It probably does say something about my sense of humour, but there is also a deep truth here. 

We often have a logical reasoned plan that we are happy to follow UNTIL it appears that something is not going to plan.  Then we PANIC!

I love economics of all sorts – macro, micro and of recent years, behavioural.   The latter focuses upon research which gives some valuable insights into how people react and subsequently behave.

One of the foundational pieces of research in this area is Daniel Kahneman’s Prospect Theory, which he developed with Amos Tversky in the late 1970’s.   Daniel Kahneman was awarded the Nobel Prize in Economics in 2002 for this and other research that he was doing in behavioural economics.

There are several key concepts within this theory, but I specifically want to look at his concept of LOSS AVERSION.  The summary of this concept is that losses are felt more strongly than equivalent gains, meaning that people are willing to take more risks to avoid a loss than they are to secure an equal gain.   To translate, if your investment drops in value by $500, you will feel this more strongly than you would if the investment gains $500.  

This was then extended to looking at Myopic Loss Aversion, where it is the natural tendency of people to focus on SHORT TERM losses and gains, rather than taking a longer term position.   This can lead to potentially “poor” decision making that can have a significant impact on long-term returns.   Many people “sell the dip and buy the high” and subsequently make very little investment return over time.

I find the research done really interesting and also quite reassuring.  It means that the feelings that I have (along with everyone else) are quite NORMAL.   It is also useful to recognise and acknowledge these feelings, because this then gives us the opportunity to respond and to not just react.

A good grounding exercise is to go back and look at WHY you made your investment in the first place.  Have your plans and goals changed?  If not, the best plan may be to get back in the ring and complete the round! 

Janet Natta is a financial adviser and director of Smart Money Advice, offering investment portfolio construction and management services to clients throughout NZ, as well as comprehensive financial planning advice to assist clients to build and protect wealth to achieve their dreams.

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