Although I don’t agree with his suggested solution to the problem, James Jessee, writing in Registered Rep, has some insightful comments on how poorly investors handle risk. In general, they are very aware of tangible risk and almost oblivious to opportunity cost:
When it comes to assessing risk in one’s investment portfolio, most people tend to think in only one dimension. Ask them what risk concerns them most, and the answer is likely to be: losing money in the stock market. Far fewer would answer: outliving my retirement savings.
This is a problem because, over a long time horizon, opportunity cost typically dwarfs the immediate danger of losing money today. This is grounded in a well-known finding in behavioral finance:
Behavioral studies show that our regret over losing money in a market decline is roughly twice as great as our euphoria over gains when the markets rise.
Losing money that was already reflected on a statement is very tangible, and investors are very distressed when markets decline. They mentally take ownership of their highest market value and tend to benchmark everything from that. When markets rise, it’s nice, but it doesn’t seem tangible unless the profits are grabbed in a sale. (This is part of the reason that investors are twice as likely to sell winners as losers.)
The long-run problem with excessive loss aversion is big opportunity cost. Risk aversion can come in different flavors. Avoiding the stock market is probably the most common foible. Other attempts to avoid risk, like buying bonds, may also backfire by exposing the investor to far more risk than they bargained for. It’s important to have a healthy respect for risk, but you can’t avoid it if you hope to preserve your purchasing power. To the extent that investors irrationally avoid risk, they are more likely to fall short of their savings and retirement goals.
