What Baseball Can Teach Us About Investing

July 09, 2014

This weekend, I watched my nephew play in a baseball tournament.  They played very well in their first game, outscoring their opponent by more than ten runs.  They played well in their second game too but an unfortunate mix up in fielding assignments when there were two outs cost them two runs late in the game that proved to be the difference. It was a hard loss and for the next few days, all I could think about was that one play. If only they had made that play they would have gotten out of the inning with the lead and quite possibly won the game.

It’s been said that the thrill of victory only lasts about 15 minute and chances are if my nephew had won his game, that’s about how long I would have been happy about it. But what is it about the agony of defeat that has me thinking about it days later? In the world of behavioral science, this is called loss aversion and as the name suggests, people don’t like to lose.

This fear of losing can also be applied to financial decisions.  Which of the following is an investor more likely to say to his or her financial advisor: “Here’s $100,000, just don’t RISK it” or “Here’s $100,000, just don’t LOSE it?”  Most investors are comfortable with the idea of risk but how many of us are comfortable with the idea of loss?

We know the markets fluctuate but that doesn’t make it easy to see a red down arrow on a financial statement.  There are at least three negative outcomes that can occur when we suffer from loss aversion.  Here they are, along with ways to overcome them:

#1 – We hang on to “losers” too long.

Since suffering loss is painful, some investors would rather hold on to under-performing investments rather than get rid of them and actually realize the loss.  I am no stranger to this.  As I’ve shared in the past, one of my worst investment experiences had to do with purchasing Internet stocks in the late 1990’s and watching them plummet until they became worthless.  Even after several of them declared bankruptcy, I held on to the worthless shares “just in case” they came back.  They never did.

In an article titled “Overcoming an Aversion to Loss,” Carl Richards offers a solution to this problem he calls the “Overnight Test.”  In his test, Richards invites the investor to imagine waking up the next day with cash instead of a position in the investment and asks them to consider whether they would use the cash to repurchase the investment or do something else.  Most, he suggests, would do something else.

#2 – We hang on to “winners” too long.

Everyone loves an investment that is performing well but an investor that hangs on to an investment for fear of missing future potential gain may end up hanging on too long.  The investment may become overvalued and the entire portfolio may become riskier than may be appropriate for the investor.  If this happens, the investor may end up selling their investments during the next market correction for fear of future loss. To overcome this challenge, the investor may want to adopt an exit strategy, employ periodic re-balancing, or simply use a target-date fund.  Whichever approach they use, it’s important to remove as much emotion as possible from the decision-making process.

#3 – We avoid investing altogether.

When I was a financial advisor, I had several clients that were so afraid of losing money that the only thing they wanted to do was invest in safe, guaranteed options.  If these investors were closer to retirement or had enough funds to achieve their financial goals without risk, I would have been fine with it but most of them had too much time and not enough assets to be either.  Also, while they may have feared the loss of principal, what they needed to understand was that there would also be a loss of purchasing power.

To help these investors, I asked them to consider variable annuities that offered the ability to invest in the market with minimum benefit guarantees.  The way I looked at it, it was in their best interest to invest the funds in order to take advantage of their long-term time horizon but I also realized that they needed the assurance that they would not lose any money.  At the time, there were several insurance companies that offered these types of products.

Whether we are talking about investing or baseball, no one likes to lose. Just don’t let your aversion to loss keep you from playing at all. In both cases, we have a lot more to gain in the long run by staying in the game.