In the last two editions of TimeWise, we explored some common human behaviours that can significantly undermine our ability to build wealth: Overconfidence and fear of missing out.
In part three of our five-part behavioural finance series, we will turn our attention to a phenomenon called loss aversion.
The term loss aversion refers to the human phenomenon of a loss being perceived as more severe than a gain of equal size. For example, a 9% gain in the value of my CSS Balanced Fund holdings may make me feel quite happy, while a 9% decline in the value of my holdings will likely cause me pain to an extent that exceeds the happiness I enjoyed from the rise in value.
Loss aversion has been well studied and the focus of much research in recent decades in the field of behavioural economics (the study of psychology in the context of economic decision-making). Some researchers have estimated the pain of loss is approximately twice as powerful as the joy experienced when we win.
Like all of the cognitive biases we are covering in this behavioural finance series, if we are not aware of the bias and take measures to protect ourselves from them, we can unintentionally make irrational financial decisions causing harm to our wealth holdings.
Some of the key ways to protect against falling prey to the negative impacts of loss aversion are:
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Follow a strategic asset allocation strategy rather than trying to time market sentiment.
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Keep the aggressive and conservative portions of your portfolio at fixed ratios by having defined target weights of each asset class held in the portfolio and periodically rebalancing the portfolio to bring it back in line with those defined target weights.
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Build a well-diversified portfolio based on buy-and-hold strategies.
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Understand that losses are inevitable in investing; rather than panic when they occur, we should view them as opportunities to learn.
Losses are inevitable in investing; rather than panic when they occur, we should view them as opportunities to learn.
The CSS advantage
Another finding in the research on loss aversion is that institutional and professional investors tend to fall prey to loss aversion biases and tendencies at rates considerably lower than average investors. This is very likely due to the fact that institutional investors (like CSS and the professional asset managers we utilize to manage investments on behalf of our members) diligently follow the above four (and more) practices.
Using our Balanced Fund as an example:
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We set a strategic asset allocation using long-term (10 to 20-year) asset class return and volatility expectations and revisit the allocation every four to five years based on refreshed long-term capital market assumptions. Negative returns are expected to occur every four to five years on average based on these assumptions and as such are part of the expected path to building long-term wealth.
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The equity, fixed income and real asset components in our Balanced Fund each have defined target weights and tolerances ranges. Should the weights of these asset classes exceed or fall below the target range, our policies require steps be taken to rebalance back into range. We do not attempt to time markets by rebalancing those asset classes that have been recent winners or away from those asset classes that have been recent losers.
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Within each of the broad asset classes noted above, we have 17 separate investment strategies diversified by investment approach, investment style, investment manager and investment market. Each of these strategies also has policy guidelines for portfolio weights as rebalancing similar to those noted above.
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Our research indicates that attempting to avoid market downturns while still capturing all of the market upside is a strategy that is likely to detract from rather than enhance returns. Accordingly, the Balanced Fund’s strategy has been to lean into those investment styles which have been academically proven to mitigate downside risk historically while continuing to add value over markets in the long term.
What this means is that the Balanced Fund is an excellent investment choice for most of our members throughout their careers. It can also be a core holding for many of our members in their retirement years. It is designed strategically, managed to maintain target weights, rebalanced regularly, and it is designed to protect on the downside when market disruptions and losses occur.
Article from the Fall/Winter 2022 issue of TimeWise.
