Imagine you are invited to play a game. You are given $20,000, and can bet $1,000, you win based on the flip of a coin. Heads, you would win $1,500; tails, you lose your $1,000 bet. Imagine you agree to the game and bet $1,000. The coin comes up tails. You bet again and the coin comes up tails and you lose another $1,000. Would you continue to play? If you do and the next flip comes up tails, would you continue? You have lost three straight times. Would you stop and walk away with your $17,000? What if you tried one more time and again lost. Would you call it quits?
What if instead of losing the first time the coin was heads? And the second flip came heads. Now you have $23,000. But on the third flip you lose $1,000 as tails comes up. Continue to play? If you do, and for a second time a tails come up and you lose another $1,000, would you take your $21,000, now a profit and walk? Or would you play again? And if you did and again the coin produced a tails. You are even with what you started with. Would you stop and go? Or would you continue?
When would you stop? Or would you play all the way to the end? A good percentage of people would stop before playing the full 20 rounds. The reality is, to maximize the return – or profit – you have to play all the way to 20 rounds without missing a single coin toss.
This game has been played as an experiment a number of times. Participants did not start with $20,000 but with $20. Statistically, by playing every round, there is an 87% chance of breaking even or making money in the game. If half the time loses and half the time wins, the player will end with $25,000. Yet most people will quit when they see two or three tails in a row. 87% chance of breaking even or making money versus only a 13% chance of losing; those are great odds. Yet 40% of the participants in the study would stop after one loss and only 58% played all 20 times. You would think as people understood the game better they would want to bet more often. Actually just the opposite happened. The longer the game went they more people dropped out.
What this says is that people are more fearful of losing money than rational and logical evaluating the odds of making money. It hurts to lose.
The standard approach for many money managers and financial advisors is this: Do not lose your client’s money. Emotionally, that probably feels good for most clients and especially those who lived through the Great Recession of 2008, but is it really in your best interest?
RW Baird did a study of all mutual funds with a 10+ year track record. They found 370 mutual funds that had done better than their benchmark by an average of 1% per year. But it was not every year they did better. 100% of the funds did worse in at least one year. 85% did worse in at least 3 years. And 1 out of four, 25%, did not only worse in three years, but worse by 5% or more for those three years. Yet each and every one of the funds at the end of ten years had done significantly better over that ten year time period.
If you are holding one of those funds, do you continue to hold on when they are not doing well? How do you know they will not continue to do worse? Do you switch and try to find the winners? Some people and advisors do. After all, isn’t the safest way to keep clients by keeping them from losing money?
Suppose today you went to your bank and withdrew $10,000 in cash with the intent to make a purchase. On your way to the store you were held up and a robber took the $10,000. How would you feel? It is an immediate and hurtful loss, right? It deprives you of what you wanted to purchase.
In my opinion that is what happens when an investor chooses loss avoidance when the probability is in the investor’s favor to make money. A 1% reduction in return over 20 years will cut the value of a portfolio by 17% and 2% reduction by over 35%. That kind of reduction is the same as the stock market drop in 2008. But unlike the stock market drop, there is no recovery. That is opportunity money that is never going to be recovered. Underperformance is like the robber who comes and steals your money and is never caught. It is gone. That is why my emphasis is striving to do better than the market over the longer-term (5 to 10 years), and it is something I have done. While past performance is not a guarantee of future outcome, to accept mediocre performance in the name of safety really does usually lose opportunity money.