Act Before You Lose

Recently, I read Who Moved My Cheese, a popular book by Dr. Spencer Johnson.  For those who have not spent the hour to do so, is about two mice, Sniff and Scurry, and two humans, Hem and Haw, who struggle in the maze to find, lose, then search again for their cheese.  Whereas the two mice are quick to recognize that the delicious cheese they had initially found had suddenly disappeared, they wasted little time launching a new and (plot spoiler alert) successful search.  In contrast, the two humans refused to accept their loss and did not search  for a new supply until their situation became desperate.  The obvious point is that things change, and remaining in denial can be destructive.

A year ago, I wrote a short  article about why people tend to make bad investment decisions.  I cited findings by Dr. Meir Statman, Professor of Finance at Santa Clara University, who has conducted extensive and interesting studies on the psychology of investments.  Reading Who Moved My Cheese prompted me to look back and see if my cheese had moved, and more importantly, what was I going to do about it?  Was I going to act like the two mice and go off in search of new opportunities?  Or was I going to act like the humans and remain in denial; paralyzed out of fear of facing reality?

Studies, such as those by Professor Statman and others, show that humans tend to be “risk averse.”¬†¬†¬†In one experiment, people given a choice between a certain gain of $3,000 as opposed to an 80% chance of gaining $4,000 and 20% chance of gaining nothing chose the certainty of earning $3,000.¬† However, when given the choice between a certain loss of $3,000 as opposed to an 80% chance of losing $4,000 and a 20% chance of losing nothing, people chose to take a chance on losing nothing — even though the odds of¬† losing a lot were four times higher!¬† In other words, we are eternal optimists if there’s any chance we might break even.¬† Risk or loss aversion is a major psychological force that often prevents investors from objectively evaluating a situation.

Professor Statman noted that one reason investors lose  is that they tend to hang onto bad investments too long in order to avoid facing reality.  Selling a house or a stock portfolio in a declining market means converting a paper loss to a real loss.   Even if there is a small percentage probability that the market will recover and the investor will break even, the studies show that the investor will hold off selling a losing stock in order to avoid facing a certain loss.  Of course, the same psychological factors cause the investor to ignore the even higher statistical probability that they will lose even more by failing to take action.  In Who Moved My Cheese, the humans held out hope that their cheese supply would return, ignoring the probability that they would starve to death if they did nothing, rather than face the reality that they had lost their cheese.   These same factors cause investors to stay put rather than sell and take a certain loss.

So, what should one do?¬† Professor Statman urges investors to diversify their portfolios, and to learn to identify and recognize their emotional reactions and their influence on their decision-making.¬† Dr. Johnson’s message is similar — evaluate your situation objectively and take action.¬† Common sense dictates that it’s always a good practice to evaluate your situation objectively and take appropriate action.¬†¬† If you’re not certain what to do, do some homework; consult with a professional; attend an educational program.¬† But take action!