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Investing

August 10, 2016

Investment losses and your retirement plan

Market losses happen. Successful investing and retirement planning mean not letting what experts call loss aversion prevent long-term asset growth.

When I was in my 20s, a group of friends and I used to rent houseboats and cruise the Trent-Severn Waterway, about 150 km north of Toronto. The boats were barely seaworthy, which was less than ideal because I’d never learned to swim. I have a vivid memory of a stormy afternoon, hanging off the stern of one boat – no life jacket – trying to toss a tow line to my friends in a disabled boat behind us. I remember two competing thoughts: This is remarkably stupid and this will be fine.

Risk taking came naturally to me and my houseboat mates. Doctors will tell you that this has to do with the part of the brain we rely on for critical thinking. The pre-frontal cortex develops slower than the emotional funhouse they call the amygdala. So while it is true that I was being stupid, it was arguably the result of a medical condition.

I like to think I’ve developed healthier attitudes about risk with age. As an investor, that doesn’t mean being risk averse. It means understanding when to take risk and how much risk I’ve been comfortable with at various stages of my life. Risk is neither a good nor a bad thing. It exists, and as part of a holistic financial plan, it should be managed to your long-term advantage.

On the other hand, a fear of risk – or more specifically a fear of losing money you’ve invested – can clearly be a bad thing. It can prevent you from realizing long-term financial goals by causing you to avoid investments that could result in a loss (i.e., almost any investment) and to overreact when losses occur. It will also put you in pretty good company. “Loss aversion,” as the experts call it, is common.

Once our pre-frontal cortex catches up with our amygdala, we become vulnerable to three behaviours – none of which are good for investors.

1. We avoid losses

Losing money makes us feel worse than winning money makes us feel good. Imagine you won $1 million one day and then promptly lost it the next. In theory you’re no further ahead or behind, so you should feel fine. But obviously that’s not the case. The loss would resonate far more than the initial good luck. Investors who avoid losses choose low-risk investments that almost always end up delivering low returns. That makes it much harder to build retirement savings.

2. We overreact to losses

When something bad happens, it triggers an impulse to change something. Often that means seeking out the safety of cash or a low-growth guaranteed investment. These short-term fixes feel right, but they get in the way of long-term capital growth. If you sold investments after the British voted to exit the European Union – an event that drove a short-term decline in capital markets around the world, only to be followed by a quick recovery – you experienced this firsthand.

3. We crave certainty

Even if we know there’s no such thing, we feel better in situations we think are safe. While that has obvious evolutionary advantages, it makes sound investment planning virtually impossible. Safe bets tend not to pay well.

Underlying all of this is an investment fundamental known as the risk-reward tradeoff. Low-risk investments typically deliver low-level returns. If you want better returns – and retirement planning generally requires the capital growth generated from higher returns– you generally have to make higher-risk investments.

Investors are usually advised to get more conservative as they get closer to retirement. Shorter time horizons make this necessary, because investors have less time to make up for losses driven by market volatility.

Young investors, however, have a much longer time horizon and so should be working the hardest to overcome these three mental blocks. Retirement is decades away, and so they have ample time to recover from even major corrections like the one we saw in 2008-2009.

But as a new study by Sun Life Global Investments makes clear, young investors would benefit from a primer on the risk-reward tradeoff. Almost half of Millennials polled described themselves as either somewhat or highly risk averse. The same percentage described their investment approach as conservative. And in the year leading up to the study, one-third of Millennials sold investments to raise cash. There are very few scenarios in which that makes sense for anyone under 30.

Take a closer look at loss aversion

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