Why Are We Scared Of A Large Portfolio?
Daniel Kahneman’s recent book Thinking, Fast and Slow, provides a wealth of information for anyone interested in decision-making. As one of the researchers contributing to behavioural economics, he has shown many times how regular economists and ordinary people make mistakes by assuming we’re rational. One thing is certain: no matter how rational you think you are, there will be some times where you aren’t as rational as you believe. And personal finance is a great area to find them.
One thing that seems to happen frequently is that someone will take big risks when they are starting out and building their small portfolio. But once it grows and they get closer to the point where they can depend on it for their income they become much more fearful. I’ve thought about this a few times before but the book made it very clear.
Some of the experiments described in the book show that people have an extreme fear or losing what they already have. Researchers gathered a group of people and gave half of them a nice coffee mug and then set them free to buy and sell with others in the group. The average price the mug owners asked to sell for was twice what the mug-less people offered to buy it for. In another experiment, people were given one of two gifts at random and then asked 15 minutes later if they would like to trade for the other. Only 10% of them traded what they got for the other choice.
This applies to your finances in countless ways. It’s natural to not take risks when you don’t need to. And when you reach a goal you won’t try as hard to exceed it even if you could still benefit from getting more. But people who pass up the opportunity to add half a million to the portfolio will feel less regret than people who lose half a million in their portfolio even though the result is similar. On average you will do twice as much to avoid a loss as you will to gain the same amount.
None of this is bad. We don’t always make perfect decisions to increase our wealth, and sometimes other things really do make us happier. However when the decisions affect things that matter to you, this knowledge can help increase your wealth.
The book goes on to describe two types of people who surprisingly aren’t affected by the fear of loss. One is people who are very poor. They see themselves as having far less than they should. Even what they have now is a “loss”. Instead of seeing a choice between gaining something new and losing something they have, they see a choice between two losses (compared to what they really want) and judge it differently.
The other type of people who aren’t affected is people who trade frequently. As described in the book, the experiment of randomly giving people a gift and then asking if they would like to exchange it was done again. This time it was at a baseball card convention, and the subjects were experienced traders who had been exchanging cards for years. They chose to trade their gift almost 50% of the time, unlike the 10% of regular people who did. They found it easier to trade since they were used to deciding if they really wanted what they currently own.
The second type of exception is a bit harder to use. If you can look for opportunities to exchange things, and take risks on small trades to see if they make you better off, you might develop the mindset of trading up without being attached to what you already have. Starting a business is another way to do this since you have to make decisions on many transactions.
The first exception is much easier to use in your finances though. When your goals are much higher than what you presently have, you’ll feel the loss every time you drift away from them. And it will be easier to stay confident in your plan since the wins and losses are easy to see. If you have no goals it will be harder to understand what you really want and you might start to see any change as a loss to avoid.
People who are deep in debt can have a much stronger motivation to save than people who are debt free and trying to invest more. About 90% of the writing on personal finance seems to involve getting out of debt. If you just got out of debt you can get stuck there unless you set a new goal for what you want next.
If you make yourself feel “poor” you can make better decisions. And if you feel aimless and scared of losing what you have now, look out into the future and set a new goal for what you want to attain or do. As long as you don’t do things that harm that goal you will know you have nothing to lose.