My four-year-old son has a magnetic responsibility chart that hangs on his bedroom door which lists daily chores and responsibilities, such as pick up your toys, brush your teeth, etc. Every night my wife goes over each category with him, assessing whether he deserves to receive a magnet for being good.
The system worked fairly well at first, but after a few weeks, the sting of foregoing a magnet due to bad behavior appeared to wear off.
As my son’s lack of enthusiasm for gaining new magnets waned, my wife suggested we give him the magnets at the beginning of each day, and as he misbehaves, the magnets are taken away. The results were impressive. My son wept and begged forgiveness as he saw the chart empty of magnets right before his very eyes. The conclusion: It was much more painful to lose something you had than it is pleasurable to gain something you didn’t have.
Investors are the same way. Whether you are 4 or 40, people do not enjoy gains in the same magnitude that they dislike losses. This concept, known as prospect theory, was introduced in 1979 by psychologist Kahneman and Tversky. This asymmetry in human decision making has lead many investors to make irrational decisions related to their investments.
The next time you examine your investment portfolio, it may be beneficial to keep prospect theory in mind. What would give you the most pain; not getting the desired return from your investments, or losing the money you’ve saved from many years of hard work?
The point is that perhaps most of us should be more diversified in our investment portfolio, so that risk is spread across more asset classes and the severity of loss is mitigated when one asset class gets hit hard. Consider looking beyond common stocks and research the risk and return profiles of other investment options such as preferred stock, convertible bonds, market neutral funds, international bonds, U.S. and international real estate investment trusts, high yield bonds, and commodities. There are plenty of investment vehicles that offer exposure into these “unconventional” asset classes.