Editor's Note: The following article is the second in an ongoing series designed to help investors better understand the emotional drives that can lead to reckless investment decisions.

"You can conquer almost any fear if you will only make up your mind to do so. For remember, fear doesn't exist anywhere except in the mind." -- Dale Carnegie, author & lecturer

The U.S. stock market kicked off 2008 by rendering an unexpectedly tough stress test on the portfolios of many investors. In January, the S&P 500^® Index fell 11% through the first 15 trading days, amid concerns about a slowing U.S. economy. Sudden corrections such as this one can test the mental fortitude of some investors as well, shaking and stirring their faith in well-crafted investment plans. The following article introduces a behavioral concept called loss aversion, an affliction that often strikes during episodic market turmoil. In its most acute form, it can cause rational people who find themselves preoccupied with the fear of sustaining losses to make costly investment decisions.

What is loss aversion?

The concept of loss aversion was introduced in the 1970s by two psychologists, Daniel Kahneman and Amos Tversky, who discovered through a series of studies that people value gains and losses differently.¹ The feeling of pain associated with losses has a more emotional impact on people than the pleasure they feel from gains, they found. Specifically, loss aversion refers to the tendency for people to strongly prefer avoiding losses as opposed to achieving an equivalent amount of gains.

In one of their early studies, Kahneman and Tversky asked subjects the following questions, forcing them to make judgments between two monetary decisions that involved prospective gains and losses of an equivalent expected value.²

1. You have $1,000 and you must pick between one of the following choices:
A) You have a 50% chance of gaining $1,000 and a 50% chance of gaining $0.
B) You have a 100% chance of gaining $500.

Faced with this scenario (above), a large majority of people (84%) chose answer B -- suggesting they were "risk averse" and willing to settle for a reasonable amount of gain, despite having a decent chance (50/50) of earning more.

2. You have $2,000 and you must pick one of the following choices:
A) You have a 50% chance of losing $1,000, and a 50% chance of losing $0.
B) You have a 100% chance of losing $500.

Faced with this scenario (above), a significant majority of people (69%) chose answer A -- suggesting that most people were willing to engage in "risk-seeking" behaviors when there was the same possibility (50/50) of avoiding a loss.

The two psychologists concluded from this and other studies that most people weighed the prospect of incurring a loss much more heavily than an equivalent gain. During the past 30 years, this finding helped advance the study of decision-making as applied to the financial markets (behavioral finance), and it underscored the view held by some psychologists that the cognitive processes often causing investors to make irrational decisions are not random, but instead reflect consistent biases of human nature.³

Loss Aversion & Investment Decisions

"One can choose to go back toward safety or forward toward growth... fear must be overcome again and again."
- Abraham Maslow, psychologist

Chronic conservatives

Loss aversion can manifest itself among investors in a number of ways. For example, it can contribute to being chronically conservative with allocations to riskier, but historically higher-performing asset classes, such as stocks. According to a 2007 Fidelity study of participants in 401k retirement plans, 16% of participants under the age of 30 had no holdings in stocks, and 11% of participants under 40 had none of their assets in stocks.⁴ For these younger investors, maintaining such an overly conservative portfolio with no allocation to stocks in a retirement account over an extended period could result in them falling short of their retirement goals.

To demonstrate the impact of excessive loss aversion on long-term investment results, consider the following: A hypothetical $1,000 investment over the past 30 years by someone maintaining a conservative portfolio comprised of 75% bonds and 25% stocks would have grown to more than $16,600. Had the same investor owned a 50%/50% mix of stocks and bonds, his or her investment would have grown to nearly $23,000; and a breakdown of 75% stocks/25% bonds would have grown to roughly $30,400 -- nearly double the more conservative mix (See Exhibit 1, below). Maintaining a long-term investment strategy that is too conservative could result in returns that fail to outpace inflation and cause a shortage of income necessary to sustain a desired retirement.

Fleet-footed market timers

During periods of high market volatility, loss aversion also can cause investors to make sudden and rash short-term decisions that may alter a smartly constructed investment strategy. There's historical precedent for such behavior. From 2004 to 2007, emerging-market stocks were one of the best-performing asset categories, returning 161% during the period.⁵ Investors poured an average of $2.2 billion per month into the asset class via mutual funds over this three-year time frame, with many perhaps recognizing both the improving structural and economic conditions in these countries, and that maintaining a small allocation to emerging markets might help boost the risk-adjusted performance of their portfolios.⁶

However, whenever emerging-market stocks experienced a sudden monthly downturn over this three-year period, many investors appeared to be overwrought with loss aversion: On average, they withdrew $328 million per month out of this market segment when it declined more than 2%.^6,7

What this behavior shows is that, even in an upwardly trending asset category, investors' fear of sustaining losses was stronger than their willingness to remain invested for the potential to achieve future gains (See Exhibit 2, below). Moving in and out of asset classes can be a daunting endeavor for even the most sophisticated investors. Those who exit an asset class earmarked for long-term diversification face the challenging future task of finding a proper reentry point to maintain their portfolio's target mix.

Investment implications

As these examples illustrate, the fear of sustaining a loss can cause some people to make investment decisions that may prevent them from reaching their objectives. Loss averse investors may become chronically conservative with their investment mix or hastily dismantle a well-designed portfolio allocation to stocks during periods of high market volatility. Historically, periodic sudden downturns have been the norm -- not the exception -- in the stock market. Being aware that the long-term trajectory of stock prices has been upward and that there is a strong propensity within human nature to avoid a loss may help keep one's portfolio allocation on track. Investors who've stayed focused on their long-term goals and adhered to a disciplined investment strategy have tended to avoid the pitfalls often associated with loss aversion.

The Market Analysis, Research and Education (MARE) group, a unit of Fidelity Management & Research Co. (FMRCo.), provides timely analysis on developments in the financial markets.

Investment decisions should be based on an individual's own goals, time horizon, and tolerance for risk.

1. Loss aversion was introduced by Kahneman and Tversky as part of a broader theory they called "Prospect Theory."
2. Source: D. Kahneman and A. Tversky, "Prospect Theory: An Analysis of Decision Under Risk," Econometrica 47, March 1979, 263-291. The copyright to this article is held by the Econometric Society. References to the article used with permission.
3. Upon accepting the 2002 Nobel Prize in economic sciences, Kahneman said, the concept of loss aversion was, I believe, our most useful contribution to the study of decision-making. The asymmetry between gains and losses solves quite a few puzzles."
4. Source: Building Futures VIII report, Fidelity Investments, 2007.
5. Emerging markets performance represented by MSCI Emerging Markets Index. Source: FMRCo (MARE) as of 12/31/07.
6. Source: Simfund, FMRCo (MARE) as of 12/31/07.
7. Note: Term referenced is defined as any one- or two-consecutive-month periods in which the MSCI Emerging Markets Index fell 2%.