Why Gains And Losses Are Not The Same In Psychology And Investment Management

Do you have a few minutes to learn an important concept on why gains and losses are not the same and how understanding the concept could make you become a better investor?

Normally, before we make an investment, we focus on how much money it’s going to make us and not the risks associated with it. Welcome, everyone. My name is Tan and I am an independent CERTIFIED FINANCIAL PLANNER™ practitioner. Today, I want to share a concept with you on why gains and losses are not the same in psychology and investment management. It is a good concept to be aware of so you can become a better investor.

Let's first look at it from a psychological standpoint. Let’s say you find $100 on the street. You feel happy and excited! So you put the money into your pocket and a few moments later, you find out your pocket had a hole and the $100 fell out. How would you feel? We would feel super sad!

We feel more pain when we lose the $100 than when we gain the $100. This concept is called loss aversion. I would like to take this opportunity to credit Daniel Kahneman and Amos Tversky for their work. I also want to thank Professor Randy Merk for sharing with me this concept when I was in graduate school at Golden Gate University.

Now let's look at how gains and losses affect your investment portfolio and the similarity with gains and losses in loss aversion.

For example, you have a $100,000 investment portfolio. The portfolio went down 25%. What is the return you need to get back to $100,000? It’s not 25%. The answer is actually 33.33%. You take the beginning balance of $100,000 divided by the current balance of $75,000 and then minus 1 equal 33.33%.

If the portfolio loss 50%, going from $100,000 to $50,000, to get back to $100,000, you will need a gain of 100%.

How about a 75% loss? Going from $100,000 to $25,000. To get back to $100,000, you will need a gain of 300% to break-even.

Wow! Look at the magnitude of the losses compare to the gains.

Why does this concept matter to you?
Similar to the $100 bill on the street example, losses weigh heavier than gains. We don't want to lose money. If we have to lose money, we will try to limit our losses as much as possible because gains and losses are not the same.

In investment management, two of the simplest ways of managing risks are:
1) having a diversified portfolio and
2) periodic rebalancing.

For more information on how to reduce portfolio risk, please check out my other video on portfolio rebalancing.

Thank you for watching. Until next time, this is Tan, your trusted advisor.

This material is for educational use only and does not constitute tax, legal, or investment advice. Information may be changed or updated without notice. Consult with a licensed professional regarding your personal circumstances.

Please do not excerpt or copy this information without prior consent from TAN Wealth Management.