Embrace Uncertainty
Thinking about money is hard. Because it is challenging people tend to take short cuts when making decisions. Primarily they lock in certain gains when available and do anything to avoid a certain loss. This tendency is referred to by psychologists as the certainty effect.
The certainty effect is fueled by our natural desire to avoid regret. Who hasn’t fixated on a potential outcome they missed out on based on an option that could have been adopted but was not.
Given its intensely personal nature past experiences with regret cause people to lock in gains prematurely when the potential for more sizeable gains exist. And to let things ride when the potential for a loss exists instead of locking in the loss before it can expand.
Lose the Reference
Because our regrets often times turn into reference points. Say you buy a stock for $100 and it steadily goes up to $150. You feel pretty good about your investment. You might feel differently if the stock takes a more volatile path and spikes up to $200 before settling at $150. You could feel like you’ve incurred a loss from the peak of $200 even though you have actually seen your wealth increase from the initial purchase price. The feeling of loss leads to a sense of regret from not selling at $200 when you had the chance.
So to avoid further regret you sell the stock for $150. After selling the stock it rockets back up to $200. The desire for certainty has led to a decision with a sub-optimal outcome. The feeling of needing to lock in a gain has caused you to miss out on the potential upside still available in your investment.
The opposite is true as well though. Say you sell at $150 and it goes back to a $100. You probably feel pretty good about your decision to lock in a gain. You shouldn’t though because the decision was made from a place of emotion. The decision to sell shouldn’t be driven by emotion. It should be driven by whether you think the value of the stock is more or less than $150.
At least in this situation you are making some money. What is more damaging though is the way the fear of regret causes people to become risk seeking when they perceive all of their options as bad.
Laugh in the face of disappointment
Loss Aversion as it relates to finances is generally a destructive behavior. Locking in a loss when the option presents itself, like a poker player folding when his bluff is called rather than staying in the hand. Typically leads to better outcomes than taking unwarranted risks in an attempt to break even. In this regard thinking in terms of cost not loss can be a useful habit to develop.
So in the poker analogy there was a cost incurred in attempting to bluff, the amount of chips wagered. As opposed to a loss that had to be made up for by staying in the hand. Futilely hoping other players would fold even though it was clear they were onto you.
Thinking this way does not come naturally though as people face a natural tendency to be disappointed when negative financial outcomes are on the table. I used to spend quite a bit of time following horse racing and still enjoy the occasional day at the track to this day. As I look back I can see how disappointing days at the track impacted my behavior when evaluating the races towards the end of the day.
Typically I would start the day by wagering on front runners with skewed odds that were good value bets given their probability of winning. On days when I would go through streaks without any of these bets paying off. I would change my strategy to start placing more exotic wagers with a lower probability of occurring that had higher payouts in an attempt to recoup my earlier losses.
Inevitably the occasional payout from this strategy gave me a false sense of confidence in its effectiveness so my behavior continued. In hindsight though it’s clear the occasional payout was not large enough to justify the strategy. Overall I incurred losses on these wagers while the front runner strategy exhibited modest gains. It would have been smarter to treat individual races as having outcomes independent of each other and stuck with the front runner strategy consistently.
Why You Should Play by the Rules
One way to approach overcoming the emotions of the certainty effect is by using rules to aid in decision making. So my rule for horse racing would have been I only place wagers when there is a horse that meets the criterion of the system I used. The key is the framework for the use of rules needs to be created prior to being faced with a decision.
This way when I went to the track and had a rough day I wouldn’t stray from my system. Why, because my rule was I only wagered when the systems criterion was met. By having a rule in place I could reduce my susceptibility to certainty effect by creating a trigger that would cause me to reevaluate risk seeking behavior when confronted with a loss.
Rules help to mitigate risk aversion when you have gains as well. So for example valuing stocks you’ve invested in can be a challenge because there is tendency to become emotionally attached to them. So instead you could put in place a rule to short circuit this attachment.
So in the earlier example if you had a 25% loss rule for selling a stock. The decision to sell at 150 would be driven by your rule for selling not the emotions related to the drop in the stock price. Because the stock had gone down 25% from its high point of 200 and whenever that happens your rule is to sell. So if it rocketed back up you wouldn’t be subjected to regret because you were following your rule not making an emotional judgment that backfired.
He's published three books. Most recently The World After Covid 19: Coexisting with the Novel Coronavirus.
His musings can be found at stevenlmiller.me. Subscribe to The Pompatus Times for updates.
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