Losses Loom Larger Than Gains

One of the trends that many people experience in the world of investing is a noted tendency to become ‘gun shy’ when they experience volatility in their investments. The reason for this is because our psychological makeup is much more afraid of loss than joyful over gains. This leads many people to either become irrationally risk averse, or to take risks that they are not aware of in a desire to achieve safety. The problem this creates is that fear of loss can make people blind to the opportunity for gain.

Volatile stock markets are hard to weather out. Watching your house lose value triggers an impulse to run for safety. However, safety is an illusion. Just because the value of something doesn’t fluctuate very much doesn’t mean that it’s safe. The price that is typically paid for value stability is low rates of return. These low rates of return can significantly impede your ability to grow long-term wealth. Acting to avoid losses frequently involves the same actions that avoid gains. Thus, in attempting to protect your financial future, you may be inadvertently handicapping your financial futures.

You Lose What You Do Not Make

One of the consistent ideas in finance and economics is the notion that you gain what you do not lose, and you lose what you do not make. Most people are very familiar with the notion of avoided losses, but blind to the idea of lost gains. The reason for this is because the lost gains are largely invisible. We are unaware of them because we did not see them. In this way, many people have allowed themselves to take risks that they didn’t even know are present. The most insidious of these is the risk of inflation. Future price increases will erode the purchasing power of dollars that you own. If your investment capital does not grow at a sufficient rate, it may be worth less (in real terms) when you retire than it is now.

This can be particularly damaging since it is unlikely that the government will be able to finance its entitlement obligations without significantly inflating the currency and eroding the purchasing power of people’s savings, investments, interest income, and annuity payments. It is likely that most people will need a substantial amount of investment income in addition to whatever is provided by the government in order to avoid a significant decrease in their standard of living during retirement. In most cases, this can only be accomplished by taking on the risk of losses that accompany exceptional investment opportunities.

Over-Reaction to Recent Trends

In general, people tend to over-emphasize events that have happened recently. In the current environment, this has led to excessive pessimism about investing. One example of this phenomenon in practice is a general tendency for people to view the recent real estate collapse in multiple markets across the country as a harbinger of risk with real estate investment. While this risk looms large in the minds of potential investors, it is accompanied by the opportunity for tremendous gains if investors possess the insight and intelligence to act. Prices have been significantly depressed in some areas (pushed below the cost of construction in a number of cases), and can present the potential for amazing rates of return.

The opposite side of this phenomenon was the stock market bubble of the late 1990’s and the real estate bubble of the mid 2000’s. In both cases, people grew to believe that values would constantly go up, and that they could never come down. A similar sentiment is now being expressed about the price of gold. In all of these cases, the values do not go up indefinitely. The same frenzy behavior that drives them up subsequently drives them back down when new buyers disappear, and people rush to cash out before the price crashes.

Fundamentals are Key

The bottom-line for any era of investing is to focus on fundamentals. The long-term success of any investment strategy is solely dependent on its underlying fundamental value. Speculation can drive the price above or below its fundamental value for a while, but it cannot keep it there permanently. All values eventually regress toward their equilibrium value. Astute investors target investments with an equilibrium value that is likely to grow so that they are not captive to market cycles. Buying at the “bottom” of a market correction is much harder to do in real life than in hindsight. It is much better to target exceptional fundamental value and invest for long-term gains.

It can be very difficult to overcome the fear of incurring losses and undertake compelling investment opportunities. Doing so requires that one muster the courage to act against the grain of popular sentiment. It can be surprisingly difficult to do, since there is comfort in following the crowd. However, comfort and profit rarely come at the same time. If you are seeking profits, it will probably require a departure from your comfort zone, and if you ware seeking comfort, it will probably mean the forfeiture of profitable opportunities.

In the end, each person must find the investment strategy that suits them best. Some are more comfortable with risk than others, and some are more comfortable with active investment than others. Regardless of your comfort level, it is important to understand that some risks will always be inherent in capturing gains. Similarly, risk is inherent in avoiding losses. All decisions that we make involve some kind of risk. It is our responsibility to make sure that we are aware of the risks we are taking in the pursuit of gains. It may well be that these risks are much less dire than the consequences of playing it safe.

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