What You're Feeling Is Normal, Biological and Curable: Loss Aversion, Regret Aversion and Herd Mentality
This is part of an ongoing series of articles about estate planning and succession planning, written by Joe Maier, JD, CPA, Senior Vice President, Director of Wealth Strategy
It is hard to remember any time comparable to the last couple of weeks. We are faced with multiple types of fear: fear of the unknown (both medical and economic); fear for our loved ones, our lives and our lifestyle; fear of bad math and fear of scary math. This article will not cover the most important of those fears. But what it will cover are those fears our brains create that could have a detrimental impact on our economic future. Behavioral finance has explained for years why and how our brains conspire against us to place our financial futures unnecessarily at risk. At times like these of unprecedented uncertainty and fear, it is important to dust off that research to better understand how our brains are reacting to this crisis. Hopefully, by having that understanding, we can avoid unnecessary damage to our wishes, hopes, dreams and desires.
I want all of you to think back on 2019. The S&P 500 grew by almost 29%. How much happiness did that growth bring you? Likely some. That growth felt good, empowering. You were likely more willing to spend on your wants and wishes, confident that, based on economic data, the economy would continue to expand and grow.
Now think about 2020, when the S&P is down about 28%. How much pain has that loss caused? My guess is an incredible amount. Behavioral and neuroscience would tell us that, on average, one dollar of loss creates twice as much pain as one dollar of gain creates happiness. This is inconsistent with how a so called rational person should feel; an economist would tell us that the pain of loss and the pleasure of growth should be equal. But, that is simply been proven untrue. And the pain and fear you are feeling, even though, currently, you have only lost a year’s worth of gains, is biologically hard-wired in us and unavoidable.
Regret aversion, to some extent, is an outgrowth of loss aversion. Regret aversion is the result of our brains imagining how we will feel if we take action (regrets of commission) or do not take action (regrets of omission) and that decision leads to loss. Regret aversion comes from the intersection of psychological principles. The first is loss aversion, we want to avoid decisions that could create loss; even if that decision has the potential of creating even greater gains. Second, decision paralysis: we want to avoid the additional pain that comes from the role of our decision in creating the loss. When we visualize that pain at the time of making decisions, we tend to make choices that are economically irrational simply to avoid regretting our personal roles in perceived losses.
Herd mentality, in turn, is a direct result of regret aversion. If a major component of regret aversion is the pain caused by our personal role in the anticipated loss, then our personal culpability, and the pain it causes, is dramatically lessened when we follow the crowd. This desire to be one of many has its roots not only in psychology or behavioral finance, but even in neurology. In studies conducted by neurologists, the portion of the brain that “lights up” when one is excluded from the group is the same area that reacts to physical pain. So when we separate from the crowd, physically or intellectually, we actually feel pain.
Understanding How We Are Feeling Right Now
So right now, we are in living in a world where a virus is
- creating abject fear about our mortality
- creating deep uncertainty in medical circles about how to combat its unprecedented speed of infection and spread
- resulting in modeling that has created concern about sufficient medical resources
- resulting in public health decisions that have created deep economic concerns
- leading to strong decreases in the price of stocks
- creating doubt about the viability of the economy, given no one knows how long it will need to be shut down to “flatten the curve” of the disease’s spread
So, we are watching our net worth steeply drop without any answers.
Now, think about these principles and how they are impacting our feelings. Due to loss aversion, we feel the pain of an already historic market drop twice as acutely as we would feel the joy in an equivalent gain. With a historic market drop, that is an incredible amount of pain. Then, one might think regret aversion would actually work to our benefit, causing us not to want to do something we will regret. Logic tells us that regret aversion will cause investors to “freeze up” and hold stocks rather than selling into a market that feels, many days, like it’s on an accelerating free fall. But then remember herd mentality. The most cogent current pain we are trying to avoid is the regret of being “the one fool” who held stocks while “all the other smart investors” were getting out. And, of course, the selloff of the market sends the obvious signal that a growing number of investors are in fact doing just that.
Combatting Our Brains: Making Decisions in Times of Uncertainty
If we were all totally rational creatures, we would come to the following conclusions:
Stocks work best in paying for our wishes, hopes, dreams and desires when they are bought low and sold high.
We cannot control stock prices, the economy, the pace of infection or the death rate. We can control our own actions including what we sell and how we spend.
We do not know enough about this virus or its long term impact on the economy to conclude that stock prices are permanently damaged.
Unless absolutely necessary (and with access to lines of credit, that would be a unique situation), stocks should not be liquidated until we have better knowledge about the long term consequences of this virus and its long-term economic impact.
But, of course, none of us is rational. We are, instead, human and as humans, we are neurologically wired to overreact to loss, be irrationally scared of regret and unconceivably follow the herd (yes mom, if my friends jumped off the bridge, I would follow them because the pain of the jump is outweighed by the pain of decision isolation).
There is really only one solution to insure that our brains do not sabotage our success. And that is to engage help. We need to work with advisers who are biographers, mirrors and consultants.
As biographers, they need to uncover and document our stories. No one owns wealth just to own wealth. We own it because of what it can do to maximize our happiness. Advisors need to understand us: what scares us and what makes us happy.
As mirrors, advisers need to remind us what really matters to us when our brains are screaming to run as fast as possible. In other words, when loss aversion and herd mentality are telling us to follow the crowd and sell into a down market, an adviser can remind us that doing so, while emotionally understandable, will mathematically place our wishes, hopes, dreams and desires in peril.
Finally, as consultants, our need to help us solve problems. For example, if our current cash holdings are not enough to pay for our needs, an advisor can help with solutions (lines of credit, payment deferrals) that do not result in long-term damage to our plans.
In scary times, it is critical to first understand one’s fear and then to decide how to deal with it. In times of economic uncertainty, it is important to remember what you can and cannot control. It is also critical to understand why you are feeling the emotions you are feeling. Once you understand that loss aversion, regret aversion and herd mentality are at play in your brain, you can get the help you need to insure that you do not let your brain sabotage your success.
Connect with your advisor today to address any concerns or questions you have.
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by Joe Maier
Joe has extensive experience helping high‐net worth individuals, family offices, business owners and corporate executives meet their wealth and legacy goals. His areas of specific interest and skill include business succession planning, financial and estate planning, and wealth transfer strategies.READ MORE about Joe Maier.