4/8/2017 You Cannot Avoid Loss; You Can Only Avoid Gain

In the market, there are good days and bad days.  Specifically, since 1950 there have been:

How the market really is
	Down	Up	Ratio
Days	7849	8952	1.14
Average	-0.67%	0.65%	0.97
Max	-20.47%	11.58%	0.57

There are more up days than bad.  But the average bad day is worse than the average good day, and the worst bad day is almost twice as great as the best good day.

But that’s not the whole story.  In “Thinking, Fast and Slow” Kahneman discusses his findings regarding prospect theory, beginning with these two questions on page 279:

Problem 1: Which do you choose?  Get $900 for sure OR 90% chance to get $1,000

Problem 2: Which do you choose?  Lose $900 for sure OR 90% chance to lose $1,000

In a number of thought experiments, he’s found that people are more likely to take the sure bet on a win, and that they are more likely to take a gamble on a loss.  To make matters worse, his research has also found that on a coin toss the average person would not flip a coin if heads lost $100 and tails gained $150, even though the math is greatly in your favor.  In fact, the break even point is a two to one ratio: we’ll flip a coin to bet our $100 against another person’s $200.  The reason is that a loss feels twice as bad as a win.

On a purely rational level, that’s nonsense.  But on a real life level, if you are out in the bush and hear a twig snap it could be something you could eat for dinner; or it could be something that could eat you for dinner.  You can afford to miss one meal, but you cannot afford becoming someone else’s meal.  We naturally avoid risk unless all choices are bad.  If you are facing an alligator in one direction and a tiger in the other you might as well flip a coin.  If all choices are bad you can only hope for luck – and THEN you’ll choose a risk.

Put those equations into the stock market, and you get this:

How the market really is					How the market feels
	Down	Up	Ratio			Down	Up	Ratio
Days	7849	8952	1.14		Days	15698	8952	0.57
Average	-0.67%	0.65%	0.97		Average	-1.34%	0.65%	0.49
Max	-20.47%	11.58%	0.57		Max	-40.93%	11.58%	0.28

Even though the market rises over time, it always feels like you’re about to lose your shirt.  And that’s why people hedge or try to time the market even when they don’t have enough to retire on.  If you have more money than you need to retire, I can understand being risk averse.  If you’re already rich, hedging might make some sense.

But 99% of us do not have enough to retire on.  For the 99%, trying to avoid loss is a fool’s game, and hedging is a sucker bet.

Pick sound investments.  Diversify.  And don’t look too hard.  Don’t watch all of your stocks turn red for the day.  If you don’t have enough to retire, don’t get risky and gamble either (the other fallacy we fall into when all options seem bad).

If you don’t have enough to retire, learn to live on less and save more for retirement.  The less you can live off of the longer your retirement dollars can be stretched, and the more you save the more dollars you’ll have to stretch.  Living on less and saving more is a win win.

But avoiding loss?  You can’t avoid loss.  You can only avoid gain by letting fear drive you into irrational trading (or an irrational refusal to invest at all).