Loss Aversion

What would you answer if you were asked this question: "How much would you want to gain from an investment to compensate you for a potential loss of R 100?" Put differently: "If there is a chance that investment X would cause you a loss of R 100, what would investment X's upside have to be for you to consider putting any of your money into it?"

If you are like most people, the answer is around R 250.

What has just been described is the so-called bias of "Loss Aversion" that is prevalent in all of us. The concept was first coined in 1979 by prominent Princeton academic, Daniel Kahneman, the father of behavioural finance.

In a nutshell, loss aversion causes us to attach more weight to the negative consequences of (potential) losses than to the advantages of (potential) gains. The interesting part though is the intensity with which loss aversion tends to manifest itself: gains need to be more than twice the magnitude of a potential loss for an investment proposition to be considered. And according to Kahneman, most of us are wired in this way.

It is this bias, which causes us to opt for so-called "safe" or low volatility investments like money market funds for example. Of course, there are two problems here:

• First, returns (especially after tax) tend to be lower than inflation, so over the long run the buying power of your money market fund gets eroded. Therefore, if inflation is your primary concern (as it should be), a money market investment is actually quite high risk!
• Second, the recent demise of African Bank has shown that even "safe" investments like money market funds can experience losses and while low risk from a capital loss perspective, they are by no means "no risk"!

This latter point needs to be emphasized in some more detail: money market funds invest in the debt securities that are issued by local banks - mainly the big four but also the likes of African Bank. They also invest in the debt securities of listed companies and government. Since banks and listed companies can fail, it follows that the notion of a risk free money market fund is an illusion. If anything positive can be taken from the failure of African Bank, it is that it has alerted consumers to this fact.

It is never pleasant to watch the value of one's investments decline - as is presently the case with the downward move of the Johannesburg Securities Exchange. But if the outperformance of inflation is a primary objective, one needs to have exposure to shares and listed property. Even though they are volatile in the short term, they present one with the best chance to preserve the purchasing power of one's capital against inflation.

Should you have a need to review your investment strategy, contact us at Mindfulmoney for a frank discussion free of any obligations.