The Pain of Financial Loss

July 3, 2018
Posted in Blog
July 3, 2018 Mduduzi Luthuli

Maybe it is a part of being a social animal that we form attachments to our environment, but the extent and the speed of that attachment is unbelievably fast. One of the first experiments exploring human attachment to their possessions was the endowment effect (later also dubbed as the “status-quo bias), which was run in the early 80’s. I would encourage you to read its findings.

In short, the endowment effect explores what informs the difference between the seller and buyer price, and the lack of willingness to accept the difference between the two. In the initial study, it was found that the seller (who had formed an attachment to an object by viewing it as their possession) placed a greater price and value to that object as opposed to the willing buyer (who through a lack of attachment) valued that same object at a lesser price and value. Put simply, when we own something, we inherently endow greater value to it, simply because it’s ours.

What causes that difference between the price of the seller and buyer, especially if that object is something that can be easily acquired in the open market? Sentimental value. If people who own things are having a difficult time of letting go of their possessions, how will we then trade in the market, if there is a great discrepancy between willingness to pay and willingness to accept. How then do we trade stocks, and more importantly, let go/ sell the losers in our investment portfolios, at an acceptable price, if we’re naturally inclined to form an attachment to what is ours? How do we change the narrative in our heads?

These are my losers and I can turn them around. I’m not wrong. I refuse to believe I’m wrong. That would make me a fool!

The PAIN of LOSS

At Luthuli Capital, many of our clients come to us after they’ve sunk a lot of money into an off-the-shelf product that doesn’t work for their financial strategy. That decision is hard and deserves to be recognized. It means acknowledging the loss (the cost of the product, and the time and effort that went into it) and evaluating new options independent of past investments. Making the choice to sell would mean realizing a loss, and I’m not just talking from a tax perspective. To some degree, it means admitting we’ve made a mistake, but we’d feel the loss, too. The problem is we’re wired to go to great lengths to avoid that feeling. This is because losses get far more weight than gains. In practice, people suffer from a loss about twice as much as they benefit from a gain of equal absolute magnitude. Put another way, the pain of losing R10 is equivalent to the joy of gaining R20.

People care (in part) about how their circumstances compare to others. This is called social comparison theory. Social comparison theory states that we determine our own social and personal worth based on how we stack up against others we perceive as somehow faring better or worse. These comparisons are called reference points. It matters whether a person is losing or gaining relative to their reference point. If our portfolio is failing whilst we perceive others to be gaining, it causes us pain. This pain can lead to paralysis. A paralysis to act, to make the painful decision to cut your losses, and move on.

To get past our aversion to loss, I recommend taking the Overnight Test. Imagine you went to bed, and overnight someone sold the losing stocks (you’re attached to) in your portfolio and replaced them with cash. The next morning, you have a choice: You can buy back the stocks for the same price, or you can take that cash and add it to your new well-designed portfolio. What would you do? Most people wouldn’t buy the stock back. Just by changing your perspective (investing cash versus getting rid of the stock), you can gain clarity and have the emotional space to make the decision you know you need to make.

Sometimes, that’s all it takes. While we’ll probably never embrace loss, it’s good to know that we can find ways to work around our aversion to it when it makes sense. Evaluate your own decision-making. Are you sacrificing opportunities because of sunk costs? Are you taking calculated risks? Overcome loss aversion by identifying what it is that you’re scared of and make a move forward. Shift loss aversion to the goal you can’t afford not to attain.

Contact me today on mduduzi@luthulicapital.com. Let me help you create a sustainable passive income from your investment. It will be painful. It will take time. It will take effort. It will be WORTH it.