Why do most people invest incorrectly?
Loss Aversion (Prospect Theory)
Before starting this article please answer with sincerity the following 3 questions:
(If you do not answer the questions, the rest of the article may not make sense)
- Consider a 50% / 50% bet (such as a flip of a fair coin) on which you can lose $10 if the coin flip turns out to be "heads". What is the smallest financial amount that you receive in case the coin flips turns to be "tails" that makes you want to play this game? NOTE: For example, if you lose $ 10 with "heads," but you win $1 billion with a "tails" you would accept this bet, right? What is the minimum for you to accept to lose $ 10 with "heads"?
- What about a possible loss of $100 with "heads"? What financial gain with "tails" do you accept to receive for this possible loss of 100 with "heads"?
- What about a $500 "heads" loss?
We ask you these questions because according to classical economics, individuals are rational. That is, if you play a game of heads and tails (50% / 50%) that you lose 10 euros if you get "heads", you should want to play this game if the value is above 10 euros. That is, if you play a very large amount of games that you lose 10 euros with "heads" and win 11 euros with "tails" you will make money. Even if the coin flip is done only once, the game is worth playing from a financial point of view, on average. However, Daniel Kahneman (the person who suggests these questions you just answered), Richard Thaler, Robert Shiller, Elinor Ostrom, and other Nobel winners, started a subgroup of economics called behavioral economics that shows that people are not rational. Among the results of their studies, they showed that people, in general, are irrational and risk-averse. That is, to lose 10 euros they want to win about 20 euros, to lose 100 euros they want to will 200, etc. In other words, on average, losing seems to be two times worse than winning, which makes no sense from a standard economics (i.e. expected utility theory).
Households have demonstrated that they prefer to take familiar gambles over unfamiliar gambles, even if they assign the identical probabilities on both gambles (Tversky and Health, 1991). This can explain, for example, why individuals invest most of their capital in their home countries (i.e. home bias), although international diversification can increase returns and decrease risks. Additionally, individuals are less likely to sell an object they own than buying that same object when they do not own it, i.e. the endowment effect (Kahneman et al, 1990). For example, sometimes, individuals are not willing to buy a soccer World Cup Final ticket for $1000. However, if they receive the ticket for free, they are also not willing to sell it for $1000. Many individuals think about the pain to lose this opportunity versus the pleasure of having the ticket. And as we saw, people tend to value losing 2 times more than winning. If individuals were perfectly rational this would not happen as one should not value an item more for selling than for buying. The rational question to ask yourself in this scenario is: “How much do I want to have that [ticket] compared with other things I could have instead?” (Kahneman, 2011).
For investments, the ideal is to be as rational as possible. In many of the interviews to become a professional investor (trader), questions similar to the ones you just answered are used to select potential candidates. However, to be 100% rational is impossible (e.g. Kahneman and Tversky, 1979). As evidence, the more you buy and sell stocks the lower are your profits, even for professionals. Therefore, how do these behavioral economics Nobels tell people to invest in stocks? They all advise to buy total market index funds that simply follow the market (e.g. S&P 500 or MSCI EAFE) since investors cannot behave more rationally than the market. In fact, they advise investors to not even look at their investments for years because checking investments may make you rethink your investment strategies. And rethinking strategies is usually a bad idea. In times of stock market crisis, Richard Thaler (the 2017 Nobel Winner) even recommends turning off your TV and not read the newspaper.
Similarly, if given the two following options, which option would you choose?
A. You receive $47.
B. You toss a coin flip. If it is heads you receive $100 if it is tails you receive $0.
The vast majority of people choose B (Kahneman, 2011). Again, the best option for an investor should be A. This question is actually relatively similar to a choice between investing in stocks vs. bonds (or leaving the money parked in your bank account), in the medium/long term. On option A you have a "fixed" amount in the future, i.e. bonds or cash. On option B, you have a much more volatile value in the future, but which tends to go higher i.e. stocks. If the amount is small enough that your game can be repeated a large number of times, you should always prefer B (stocks). Stocks far outperform bonds in the medium and long terms, let alone cash parked in the bank account. It is true that stock investments can have no return or negative return even in long periods of time. However, the odds that stocks will outperform bonds and cash is high enough that the expected value of investing in stocks is far greater than bonds or cash. Very few amateur investors think this way (e.g. Rabin, 2000).
This loss aversion phenomenon often leads investors to have investment portfolios with lower returns and higher risks than they could. Moreover, the fact that family and friends invest similarly wrong, if even they do not have significant training in economics or finance, make this loss aversion problem even harder to overcome.
"The role of an [financial] advisor is to press people toward rationality up to a point [...]. They will cause people, in theory, to trade less, to turnover less, and one very important thing, to check their results less frequently. Frequent checking of results causes people to want to change what they are doing and people do poorly when they change what they are doing." - Daniel Kahneman, The 2002 Nobel Prize Winner
- Kahneman, Daniel, and Amos Tversky (1979). “Prospect Theory: An Analysis of Decision Under Risk.” Econometrica 47(2): 263-291.
- Kahneman, Daniel, Jack Knetsch, and Richard Thaler (1990). "Experimental Tests of the Endowment Effect and the Coase Theorem". Journal of Political Economy. 98 (6): 1325–1348.
- Kahneman, Daniel (2011). Thinking, Fast And Slow. New York : Farrar, Straus And Giroux.
- Rabin, Matthew (2000). “Risk Aversion and Expected-Utility Theory: A Calibration Theorem.” Econometrica 68(5): 1281-1292.
- Tversky, Amos and Chip Health (1991). "Preference and belief: Ambiguity and competence in choice under uncertainty." Journal of Risk and Uncertainty 4(1): 5–28.
IMPORTANT: THERE IS NO ONE BEST TAX OR INVESTMENT STRATEGY. IT ALL DEPENDS ON YOUR GOALS, RESOURCES, AND CITIZENSHIP.
For example, are you willing to move abroad? If so, where? How long do want to stay in each place? What is your annual income? How much money are you willing to invest? Do you want short term gains or long-term investments? What is (are) the source(s) of your income? How much taxes do you pay annually? Do you want to decrease your tax duties or completely remove them? Do you feel like you want to pay some taxes even if you do not need to? What is your citizenship? Do you have multiple citizenships? Depending on each of these answers the best investment/tax strategy for you will differ. In order to see what option is best for you and to help with the implementation of the strategy feel free to reach out to us. You do not need to be rich to create a global investment portfolio. Most of the bank and brokerage accounts we open do not have minimum initial deposit or maintenance fee. Thus, you can invest as much as you want or even leave the accounts empty until you have enough capital or interest to invest abroad.