Book a loss on my portfolio? No way!

imgbd MasterMind is a joint initiative between Sundaram Mutual and Wealth Forum, in which we offer insights into how you can become a more effective advisor to your clients, by understanding them better, understanding how they think, understanding how they take financial decisions. This gateway into your clients' minds we believe will help you relate better to them, communicate more effectively with them and thus serve them better. Mastering your client's mind is your gateway to becoming a more successful advisor. Its not for nothing that they say, "Its all in the mind!"

In the previous article (Click Here), we looked at the concept of Loss Aversion, discussed how it impacts critical asset allocation decisions and also explored alternatives that advisors can adopt to help clients avoid the pitfall of Loss Aversion. In this article, we look at another angle of loss aversion - on how and why investors react to losses that they see in their portfolio statements and how we can help them make better investment decisions with their existing portfolios.

An example from the previous article

In the previous article (Click Here), we asked you to think of this situation : an investor has invested Rs.100,000 each in Fund A and Fund B. 1 year later, Fund A has appreciated by 25% to Rs.125,000 while Fund B fared poorly and is now worth Rs.75,000. The portfolio statement looks something like this :


The portfolio statement happens to be of one of your clients. You may read the statement exactly as shown in the table above, but your client will most likely see this table a lot differently. This is the picture that is most likely to form in his mind as he sees the portfolio statement :


We discussed, in the previous article, that this frame of reference is a right brain emotion called loss aversion, which states that for the human mind, the pain of loss is twice the joy of gain. Now, lets take this example forward and see what would be a typical investor reaction and why.

After seeing red, what next?

So, we know the first reaction : the loss is highlighted in the mind in bold red. It has created a lot of strife in the mind, the mind is now agitated. The investor is in short, unhappy. Nobody likes to be happy, nobody likes to remain unhappy. Loss aversion has created a sense of despair about that one investment. The mind is instantly looking for a solution to eradicate this despair and bring back a sense of happiness and well being.

What's the easiest and quickest way that the loss can be eradicated? By believing that there is no loss. How can this be done? By believing that if the investment is held for a little longer, it will recover and wipe out the loss. Whether it actually pans out this way or no, only time will tell. But for now, by converting the despair of the loss that the investor sees in his portfolio into hope that the loss will get wiped out, his mind has successfully and instantly managed away the pain that the loss was causing him. His mind is made up : lets hold onto Fund B for some more time, wait till it comes back to cost and then get rid of it the moment it gets there.

Your left brain analysis vs your client's right brain emotion

Let's say (purely for the sake of an example), that you, as his advisor, never really cared to understand the way your investor thinks, but have come now for a portfolio review meeting, armed with lots of facts and figures. You begin by explaining that Fund A, which is an IT sector fund, has benefitted by the sharp depreciation of the rupee in the last year. You believe that good times for the IT sector will continue on the back of resurgent global growth and continued currency weakness. On the other hand, Fund B, which is an infra sector fund, performed weakly due to continued high interest rates, lack of Government spending, continued red tape in the infra sector, and a host of such fundamental reasons which impacted these businesses and therefore their share prices. Having reviewed the relative merits of both sectors, you are of the opinion that the IT sector will continue to do well in the coming year and infra will continue to be weak (these may not be your opinions, but lets just go with them, for the sake of this example). On the basis of this carefully considered and well researched homework, you advise your client to exit Fund B and reinvest that money into Fund A.

How do you think your client will react? Ask you immediately for the forms to sign to implement this very sensible advice? Or, more likely, look for ways to postpone the decision, if not outright reject your advice? If you see him unwilling to go by your advice, its not because he has a different view on IT vs infra sectors. Chances are that the relative merits of both these sectors are the last thing on his mind. Here's what is more likely to be happening in your client's mind :

  • Book a loss? Never!

  • This advisor gave me poor advice, made me lose money, and is now coming with all sorts of stories why I should switch my portfolio around, so that he can make more money from me!

Why are investors so averse to booking a loss?

Why are so many investors averse to booking a loss? After all, if there is a lemon in the portfolio, isn't it better to get rid of it rather than it becoming a permanent eye sore every time the portfolio is reviewed? What is the joy that one can get by holding on to a bad investment forever? The key to understanding this seemingly irrational behavior is to understand how the human minds instinctively deals with loss aversion. As mentioned above, the most likely investor reaction to seeing a mark-to-market loss in the portfolio is to convert that despair into hope - hope that the fortunes of that stock or fund will turn around and that the loss will be eventually avoided. If this is the frame of mind, anybody who tells the investor to book the loss is actually denying him that hope. He is being forced to go through the pain of realizing a permanent loss of capital, while he would have been happier living in hope that the pain can be avoided. Behavioural scientists call this reaction the disposition effect.

Short term trading buy becomes long term investment

Disposition effect explains why an investor who bought a stock as a short term trading call, converts it into a long term holding when it depreciates in value. Although it is loss aversion that prevents him from cutting loss from a bad trade, the investor in him has to justify this decision. Suddenly discovering the merits of the stock as a long term holding, discovering the virtues of the fundamentals (which never came in the picture when the trading buy was initiated), reposing faith in management quality, calling it a blue chip - all of these could well be nothing but rationalizations to cover up for a basic emotional decision not to book a loss on a bad trade.

How can you help your clients overcome loss aversion?

Now, let's come back to the hypothetical case of you and your client and the discussion on Fund A (IT sector) and Fund B (infra sector). We now know that irrespective of the compelling logic of our arguments, our client is perhaps not going to act on our suggestion to book the loss and switch to a fund we believe has stronger prospects. How do we get the client to do what we strongly believe is best for his portfolio?

It's a tough one, and many advisors have tried various strategies to help get around loss aversion and align client portfolios to changing market realities. There are obviously no right or wrong answers to this one - finally, whatever helps you get your client to take the right action, is the correct answer for you. Here is however a pointer to what can lead you towards the desired outcome :

  • Understand first that the client is hurting badly about the loss. This is the first thing he wants to talk about. Deal with that aspect first, show that you really feel as bad as he does about the loss. Empathizing is different from saying you made a mistake (by the way, if it was your mistake, its best to own up and say sorry!). But, if you genuinely got a call wrong and it wasn't a reckless or ill-thought call, you are not really helping matters by only defending your position by strenuously discussing how markets changed beyond what any expert could predict and so on. How about first starting the chat with how bad you feel about the loss in the portfolio, and then go on to explain how the call perhaps went wrong? If you show your client that you understand the pain and feel it likewise, you are allowing all those pent up negative emotions to be dealt with and taken away from the table, so that a meaningful conversation about the road ahead can then start.

  • Understand that the primary emotion driving the decision to avoid booking a loss in an investment that is going downhill, is not a fundamental call on the investment, but an emotional call based on hope of recovering the loss. Whatever alternative you offer must therefore explicitly offer an alternative hope of recouping the loss. Unless you showcase an explicit prospect of hope of recouping the loss, your client may not budge. If he sees hope from an alternative solution, he may be that much more willing to try it out. So, by all means, have a discussion on the relative merits of the IT and infra stories as you see them, but do round off your pitch with something that suggests that you strongly believe this portfolio restructuring in your view has the best chance of recouping the loss.

What you communicate and how you communicate is best left to you - you know your clients best. But do try to include these two elements in your client conversations, and you might just find clients that much more willing to get over their loss aversion and take better investment decisions.

All content in MasterMind is created by Wealth Forum and should not be construed as an opinion of Sundaram Mutual Fund.

Share this article