Our minds are wired to hate losses much more than we love gains, and even more so given recent history, writes MoneyShow.com senior editor Igor Greenwald.
How much of our current wealth should we risk in pursuit of additional wealth? How many birds in the bush is the one in hand worth?
It turns out that the proverb has it about right. In 1963, MIT economics professor Paul Samuelson wrote a paper describing a bet he’d offered to a colleague: a $200 gain for winning a coin flip vs. a $100 loss for guessing wrong.
The colleague declined: “I would feel the $100 loss more than the $200 gain. But I’ll take you on if you promise to let me make 100 such bets.” Though risk-averse, the colleague was no dummy: his counter-proposal had an expected gain of $5,000 and a better than 99.5% chance of winning money.
Samuelson concluded that having rejected one such bet, his colleague should have logically rejected all of them. A hundred flips didn’t cut risk so much as redistribute it, increasing the win expectancy, but also the maximum potential loss.
In a 1999 follow-up, Shlomo Benartzi and Richard Thaler offered a proposition similar to Samuelson’s, albeit with lower stakes, to three distinct groups: MBA students at the University of Chicago, undergraduate business students at the University of Southern California, and random visitors to a Los Angeles coffee shop.
A majority in each of the three groups accepted a single flip bet, but only the MBA candidates were even more eager to commit to 100 flips, whereas only half of the UCLA students and 43% of coffee shop visitors were willing to do so. Once the groups were shown the relevant statistical probabilities, wide majorities in all three groups volunteered to gamble on 100 flips, of course.
Samuelson was on the money in constructing his bet: subsequent research has found that a loss subtracts twice as much from our mental accounting as a comparable gain would add. And the upshot from the 1999 experiment is that not only are we wired to dislike losses more than we like gains, but that we’re not particularly good at weighing the risks and rewards as they’re compounded by repetition, even when the probabilities are known to be 50-50.
In stocks, of course, the probabilities are fuzzier than that. And I suspect that loss aversion is near all-time highs three years after most investors lost a huge coin flip. Having been badly burned, Main Street loathes risk. The continued flight of cash from equity mutual funds into bonds is one manifestation.
Another is last year’s fashion for dividend-paying stocks. Though taxed twice, dividends offer some certainty for investors who have never been less certain. After a decade without capital gains we’ve invested dividends with the magical property of separating good stocks from bad, turning them into a gauge of corporate virility.
Many investors want to get paid right away for being brave enough to venture beyond minimally rewarding savings accounts. A quarterly dividend keeps loss aversion at bay by providing a near-term gain. Every three months, the investor “wins,” with the another small “win” on tap the next season.
Of course, dividends offer no real defense against a hefty capital loss. And their appeal has been on the wane of late, with riskier plays leading this year’s market rally. Quite recently, growth stocks have begun to outperform.
Many large-cap growth stocks have been less risky than “value” counterparts for some time. Is EMC (EMC), growing sales at 32% while priced below 17 times earnings, really riskier than Procter & Gamble (PG), with a price-to-earnings ratio of 17 and a 4% sales growth rate?
Hardly. P&G’s 3% dividend notwithstanding, EMC’s 34% gain year-to-date provides a generous cushion against subsequent disappointment, and suggests investors have identified the real bargain.
Still, EMC is certainly exposed to the vagaries of the global economy, which is not exactly firing on all cylinders at the moment. And that exposure to a potentially lean near-term future is a liability. Many of the professional money managers excited about stocks’ prospects in 2016 seem less enthused for 2012 and 2013.
This has me, in turn, excited for growth stocks with no meaningful sales right now. This means they’re not exposed to Europe, China, or the US job’s market’s ups and downs. It also implies that they’re most discounted by loss aversion, since the absence of a here-and-now business presents huge risk.
Tomorrow, I’ll go over three speculative biotech stocks that fit the bill as “tomorrow” stories that could easily lose 50%, or double. I believe loss aversion is holding down their price in the face of significant opportunities.
In the meantime, food for thought: How far would the odds have to be tilted in your favor on a coin flip to make it enticing? How big a bet would be tolerable? Would you bet half of everything you own at 2:1 odds? How about at 3:1?