Investment Biases and Loss Aversion Psychology

This article is an excerpt from the Shortform summary of "Nudge" by Richard H. Thaler and Cass R. Sunstein. Shortform has the world's best summaries of books you should be reading.

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What are the most common investment biases? How do the authors of Nudge suggest overcoming those biases?

In the book Nudge, authors Thaler and Sunstein note that the main reason people are nervous about investing and about defined contribution retirement benefits is because of the loss aversion bias. The authors discuss the nuances of loss aversion and some tips to overcome it.

Continue below for advice on how to avoid investment biases, according to the authors of Nudge.

Defaults, Investment Choices, and Biases

In Nudge, Thaler and Sunstein note that not long ago, the most common retirement plan offered by employers was a “defined benefit” plan—that is, one that made fixed payments to the beneficiary based on tenure and salary. Now, the most common type of retirement benefit is a “defined contribution” plan, in which employees make periodic contributions to a tax-sheltered investment account, on the assumption that they’ll get back an increased return in later years.

(Shortform note: In 2020, 64% of private industry workers had access to a defined contribution plan while only 15% had access to defined benefit plans. In 1990, those numbers were 34% and 35%, respectively, showing that slightly more people used defined benefit plans in the past.)

This shift put a greater decision-making burden on workers: What level of risk am I willing to take, and how do I allocate my savings accordingly? Should I be investing in stocks or bonds or both? How often should I revisit my allocation of assets, and what real-world information should I be looking for to know when to change it?

According to classically trained economists, we should have no trouble making the right investment choices. This is because, in most economic models of human behavior, people are thought of as eminently rational and self-interested actors who consistently make the best decisions for themselves—that is, people are homo economicus.

The Critique of Homo Economicus

Introduced by classical economists like Adam Smith and John Stuart Mill, the term homo economicus—“economic man”—conceives of people as predictably rational and self-interested, thus able to make the most beneficial economic choices for themselves. (In more technical terms, when faced with a decision, homo economicus makes the choice that “maximizes expected utility.”) In most of the economics research of the last century, people are modeled in just this way: as able to maximize their own economic benefit.

With the advent of behavioral psychology and economics, however, researchers have established that homo economicus is a fiction—that people’s rationality is “bounded” by any number of cognitive and contextual factors. (In fact, one study determined that real people who meet all the criteria of homo economicus might be diagnosed as psychopathic.) Thus—at least according to proponents of people’s “bounded rationality”—much of the economics literature rests on a flawed assumption and so can’t be applied to real-world policy.

Debates are ongoing about the accuracy of economic models that rely on homo economicus. Some commentators find that people do in fact act consistently and self-interestedly when faced with decisions while others maintain homo economicus is a chimera. Thaler and Sunstein, for their part, fall into the latter camp, arguing that “Econs”—or “economic people”—simply do not exist.

Thaler and Sunstein argue that if people indeed met the criteria of homo economicus, we would have no trouble with investing biases such as (1) recognizing that stocks outperform bonds historically and (2) calculating our tolerance for risk based on the probability distribution of stock market returns. But, because we’re human, the complexities and variability of defined-contribution plans cause us to make mistakes that end up—quite literally—costing us.

One way to remedy these mistakes, they suggest, is with better defaults, specifically “target maturity funds” that automatically reallocate their asset mix based on a worker’s age. A target maturity fund will have a riskier asset allocation—more stocks, fewer bonds—when a worker is young and gradually recalibrate as the worker ages. By the time the worker retires, his portfolio will be heavily weighted toward fixed-income assets like bonds.

(Shortform note: Nassim Nicholas Taleb explores the biases that make people bad at assessing risk in his book Fooled by Randomness, in which he argues that when we make decisions, we are typically guided by our primitive brain, which runs on emotion, likes simplicity, and has trouble understanding abstract concepts. When investing, we therefore do things like act impulsively, sell a stock too soon if it’s doing poorly (even if its long-term prospects are good), and misjudge our abilities to play the stock market—in reality, it’s luck that rules the market and determines most success, not our skill in choosing stocks. Thaler and Sunstein’s solution of using targeted maturity funds to sidestep our natural impulses addresses Taleb’s concerns, as it takes the decision-making process away from our primitive brain and relies instead on rational algorithms.) 

The authors contend that the most destructive cognitive investing bias when it comes to investing is loss aversion. Numerous studies—including Daniel Kahneman and Amos Tversky’s “Prospect Theory: An Analysis of Decision under Risk”—have shown that people, as mentioned earlier, tend to feel losses more strongly than they feel gains. Because of this, we frequently make unideal decisions to avert losses rather than realize gains.

Experimental Evidence of Loss Aversion

A famous illustration of loss aversion comes from one of Thaler’s “Anomalies” columns in the Journal of Economic Perspectives. To test people’s economic decision-making, Thaler and his coauthors divided a large lecture class into three groups and had them pick prices for a souvenir coffee mug. The three groups were (1) “sellers,” who were given the mug and had to pick a sell price; (2) “buyers,” who weren’t given the mug and had to pick a buy price; and (3) “choosers,” who weren’t given a mug but could choose either the mug or the cash equivalent of its price. (There was a limited number of price options ranging from $0.25 to $9.25.) 

The median price chosen by the sellers was $7.12, while the median prices chosen by the buyers and choosers were $2.87 and $3.12 respectively. In other words—as noted above—the sellers overvalued the loss of the mug by a 2:1 margin. (Thaler coined the term “endowment effect” to describe this phenomenon. According to this theory, people price items they already own higher than they would if they were purchasing the item anew.)

Subsequent researchers have offered different interpretations of the mug experiment, however. For example, one study found that loss aversion wasn’t the driving force behind the price disparities; rather, it was inertia—that is, neither the buyers nor the sellers were sure what the mug was worth to them, so the prices reflect the necessary incentives to bother buying or selling the mug.)

Thaler and Sunstein write that when it comes to investing, loss aversion typically manifests itself in overreactions to short-term market fluctuations. For example, people will fixate on the monthly, weekly, or even daily movements of the market and potentially change their asset allocations on those bases—when, in fact, these fluctuations belie the long-term upward trend of the market. They point to a study of retirement plans administered by Vanguard that showed new enrollees allotting 58% of their account to stocks in 1992, 74% by 2000 (when tech stocks were booming), and 54% by 2002 (after the tech bubble burst). In other words, these employees bought high and sold low—the exact opposite of what they should have done. A target maturity fund, which reallocates over the long run, prevents us from indulging our bias against losses

A Nuance of the Vanguard Illustration

Despite the strength of their argument, the authors may be presenting the Vanguard example in a slightly misleading way. The study only looked at how new enrollees allocated their funds. It did not track their subsequent market movements. It did this because generally, due to inertia, once people have decided on a percentage of allocation, they don’t bother to change it, so the best way to track how the market’s current performance affects behavior is to look at times when people are actively making these decisions—generally, when they first join a company and fill out the forms. Thus, the authors’ assertion that people buy high and sell low is a little misleading—the study doesn’t actually say if they sold their holdings, it only says that they bought less when the market was low. 

The effect, however, is essentially the same. People invested more heavily in the market when it was already inflated. Experts might further point out that an investor can buy high and still make money if they hold those assets. For example, if an investor had bought Amazon stock in December 1999, he would have paid around $90 a share. That investor would have seen the stock price plummet to single digits in late 2001 after the dot-com bubble burst. But, if he continued to hold the stock through today, he would have seen the share price grow to over $3,000.
Investment Biases and Loss Aversion Psychology

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Hannah Aster

Hannah graduated summa cum laude with a degree in English and double minors in Professional Writing and Creative Writing. She grew up reading books like Harry Potter and His Dark Materials and has always carried a passion for fiction. However, Hannah transitioned to non-fiction writing when she started her travel website in 2018 and now enjoys sharing travel guides and trying to inspire others to see the world.

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