When a friend recently told me she wanted to invest more money in bonds, I was surprised. Not just because we rarely discuss specific investments. (I'm uncomfortable giving friends financial advice for obvious reasons). But mostly because she's considering loading up on bonds right now. Wow, bad timing.

So despite my self-imposed rule to not interfere, I couldn't help blurting out, "Are you sure? Don't you already have bonds?" She said she did, but then added how much she appreciates bond funds' regular gains. Of course it's a natural impulse to seek security. But my friend's dilemma illustrates a classic case of what behavioral economists call loss aversion.
And loss aversion poses a huge threat to investors. Behavioral economists, whose insights from the fields of economics and psychology shed light on how we make our financial and investment decisions, find that we are more motivated to prevent loss than we are by the possibility of gains.

Last Year's Scars Haven't Healed


Why? It's simple -- we don't cope well with loss. Studies show we experience twice the emotional impact of a loss compared to any pleasure we feel from an equivalent gain. This compels us to instinctively find ways to limit loss, or even the potential of loss. After surviving a whopping 37% plunge in the Standard & Poor's 500 Index in 2008 as the financial crisis exploded, it's obvious where today's fear comes from.

"Investors clearly are scarred from what they experienced last year," says Christine Benz, director of personal finance with the Chicago-based investment research firm Morningstar. (MORN). "They're saying a safe, but low return is preferable to a higher, but potentially erratic return."

Ironically, many investment decisions attempting to avoid pain have the opposite and unintended effect of cementing losses over time. Benz compared mutual funds' returns with the actual returns that most investors pocketed over a 10-year period and discovered wide gaps. Investors sometimes lost more than half of the entire return -- more than 1% on an average annualized basis -- in every mutual fund category Benz examined over the 10-year period through the end of September. The returns are asset weighted, meaning that larger funds' returns have a greater weight than smaller funds' returns.

The missed returns ranged from 1.29% on an average asset-weighted basis for U.S. diversified funds -- the funds gained 2.13% on an average annualized basis over 10 years, while average investors collected just 0.84% -- to 2.73% for U.S. sector funds. In this case, the funds rose 5.45%, but average investors earned just 2.72%.

Losing Once Makes Us Gun Shy

Benz also found a strong correlation between extremely volatile investments and higher lost returns, as investors appear to trade out of losing positions before they fully recover. Notably, blended, all-in-one funds that have pre-mixed allocations to stocks, bonds and other investments seem to help investors stay the course and gather a greater percentage of the gain, Benz says. She believes when investors don't see the volatility, they don't react to it.

What's to blame for this self-defeating behavior? "It's this hunker down phenomenon," explains Michael Mauboussin, chief investment strategist with Legg Mason Capital Management, who wrote Think Twice: Harnessing the Power of Counterintuition. And each person's loss aversion is unique and may improve, or worsen, depending on his or her own recent personal experiences.

Mauboussin points to Antonio Damasio's work that studies this phenomenon. Damasio gathered three groups -- normal, control (or similar to average investors) and target. The target group was made up of individuals who had suffered brain damage that numbed their ability to feel fear or greed, but did not affect their analytical skills.

He gave them all $20 with a goal to make as much money as possible at the end of 20 rounds of a game. After each round of the game, they could choose to keep their money or hand it over to a researcher who would flip a coin where they stood a 50% chance of winning. The results? The target group played twice as many rounds of the game and earned 13% more than everyone else. In other words, losing money prompted the people who could feel fear and greed to avoid losses, which actually prevented them from making more.

"To make it more profound, people will willingly give up positive expected value bets after having recently suffered losses," Mauboussin says.

It's an extreme example, but one that may be worth considering for any investors still smarting from last year's pain: resist the temptation to leave the game. Be aware of your instincts, and how they can work against your best interests.

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