by Mark Neil

Recently I was reading a fascinating book on investor psychology by Hersch Shefrin that related a valuable lesson on investing.  He illustrated the lesson by telling a story, one that we can all relate to.

Over 25 years ago a young professional couple was looking for ways to invest that would reward them with above average rates of return.   James, a good friend of theirs who owed the couple a favor came to Bill and his wife with an opportunity to invest in real estate.  James described the investment as a “sure thing.”  True to his word he reported back a year later that the property had indeed done very well.  They had more than doubled their money.

Bill was quite excited about the outcome of this investment and was naturally very interested when James returned later that year with a similar type of deal.  Bill and his wife, who recently had given birth to a daughter, were looking for ways to pay for her future college expenses.  This deal was bigger and it would require all of their savings of $17,500 and they would have to sign a promissory note for $85,000.  It was also riskier for Bill and his wife, but they quickly made up their mind.  They signed up and became equal partners in the land deal with James. 

This deal however wasn’t quite as easy as the first one.  A number of delays and problems with the property caused the bank to ask for more money when it came time to renew the loan.  Bill had to come up with another $10,000.  Fortunately he and his wife had been able to save that amount in the preceeding months.  They gave the money to James and waited for the payoff.

A few more years went by and the prospects for the investment become even more dismal.  James was embarrassed about the problems with the project and he approached Bill and his wife and offered to take over the interest payments and responsibility for the loan.  In exchange they would turn over their interest in the property and limit their loss to the $27,500 they had already invested.  The young couple turned James down and reminded him that this investment was to be for their daughter’s college expenses.  They were convinced it would work out and they continued to make payments on the loan.

Three more years go by.  The problems are mounting with the development property.  A real estate agent offers James $43,900 for the entire property.  James informs the young couple that he has decided to accept the offer.  They just have to sign over their interest and he will assume responsibility for the remainder of the loan and future interest payments.  They can cut their losses and get out of the investment or continue to be responsible for the loan principal and interest payments.

Given these circumstances what would you have done?  Would you have seen the investment through or would you have cut your losses and got out?

If you are like the majority of people who suffer from an acute case of loss aversion, you would have stayed in the investment and rode it out.

Loss aversion means you have great difficulty in coming to grips with your losses.  You continue to throw good money after bad with the expectation that the investment will eventually work out.  Facing the fact that you made a mistake is painful, and like most humans you don’t handle losses on your investments very well.  

A symptom of loss aversion is “get-evenitis”.  “Get evenitis” seems to be a reasonable remedy for loss aversion, but it just makes it worse.  Rather than face the loss you continue to hold on.  You put more money into it with the expectation that if you wait long enough it will go back up to the price you paid for it.  

The trouble is the price seldom recovers, and it usually falls further to the point I call the “what the heck” level.  That’s where the price is so low that if you did sell you would have so little left over, you might as well hang on to it.  So you do and you get to avoid facing the loss. 

The only consolation you have when experiencing loss aversion is that you have plenty of company.  Professional investors, money managers and corporate executives all routinely fall victim to this affliction.   In most cases they don’t even know it is happening to them.  They let their egos and pride get in the way of using sound rules and principals to counteract the behavior.

The bottom line is if you can’t make investment decisions without detaching yourself from the emotions surrounding them, you should find a professional who can do it for you.  There is no shame in admitting you are human when it comes to investing.  Develop sound investment rules and stick to them and you will find yourself a lot happier and a lot wealthier.

By the way.  The story at the beginning of this article was about Bill and Hilary Clinton and the Whitewater scandal.  James was none other than Jim McDougal, their real estate partner in that deal.   Interestingly enough Bill and Hilary’s aversion to loss inevitably impacted Bill’s legacy in the White House.  His inability to cut his losses and move on eventually caused the Ken Starr investigations and the fiasco with Monica Lewinsky.  With Ms. Lewinsky he had the choice of admitting his illicit behavior and face the music or gamble that he could talk his way out of it.  

Being loss averse he chose the latter and the rest is history.

Contact Mark Neil at:
Northwest Wealth Advisors, Inc 
0605 SW Taylors Ferry Road
Portland, OR 97219
Office: (503) 478-6632 
Fax: (503) 595-1863 
Email: mneil@nwwealtadvisors.com 

© 2003 Mark Neil