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Ryan Modesto.

Ryan Modesto, CFA, is CEO at 5i Research, a conflict-free investment research provider for retail investors offering research reports, model portfolios and investor Q&A. 5i Research provides content under an agreement with The Globe and Mail, which receives royalty compensation. Try it.

A lot of discussion has occurred with the recent pullback in equity markets. Year-to-date, the TSX is down roughly 6 per cent from its peak and the S&P 500 is down just over 10 per cent from peak to trough (but is quickly making those losses back). While there has been a lot of fear and panic surrounding this decline, there did not seem to be much concern when the S&P 500 rallied 7.5 per cent at the beginning of the year or when it rose 16.8 per cent over the last year and 79 per cent over the last five years!

So why is that the case? Regardless of how strong markets have been, why does the world seem like it is imploding over small relative losses? There is an answer, and that answer is the concept of loss aversion.

Loss aversion, often referred to as prospect theory, is part of a school of thought that melds psychology and investing. This school is also known as behavioural economics. While a lot of finance is focused on analytical routines, behavioural economics acknowledges that at the end of the day, humans are making the rules and decisions and, all humans are susceptible to ingrained behavioural biases and conflicts. If an individual looks at an investment or portfolio without a behavioural lens, they only get half the picture.

Loss aversion, specifically, is the idea that the psychological pain of losing is far greater than the pleasure experienced from winning. In many studies, subjects choose to avoid a loss even if it has a low probability of occurring. In other words, irrational decisions are made when an investor is faced with losses because a loss feels worse than a gain. This has implications for all investors.

Don't count on besting human evolution

Loss aversion has developed in each and every one of us for a reason. In the wild, even a small mistake could mean death. And so, humans overweight the importance of potential mistakes. It has become a part of our makeup. Considering this, even investors with the best intentions and education should not expect to be able to overcome this bias. Animal instincts will win out more often than not, and ignoring that reality can be dangerous. We often hear investors say they could withstand a 25 per cent drawdown in a portfolio or would be ready to buy into the next market crash. These comments are fine when things are calm, but the reality is often much different different when you feel sick to your stomach in a market downturn and everyone is talking about how the sky is falling. Even investors with the best intentions should still expect that making a specific rational decision in the heat of things may not be as easy as originally thought.

Understand markets are likely overweighting current negative events

Understanding the biases all investors face can also help tune out the noise. In this case, we actually have two behavioural biases that probably compound one another. First, we have the fear of a loss being overweighted in an investor's mind. So as markets decline, everyone feels it, everyone talks about it, and many get the sense that it is only going to get worse. The noise is amplified much more than it should be in downturns, because it hurts more. In reality, a 10-per-cent correction is a normal event. An investor should be cautious putting any money into a market if they are not comfortable with a 10-per-cent decline in the short term.

The other bias that builds on loss aversion is recency bias, in which investors put greater importance on recent events. So even though the S&P 500 has grown by over 100 per cent (excluding dividends) in the past 10 years, investors are more focused on the 10-per-cent loss over the last month. Both of these biases can make a downturn feel way worse than it really is.

Act accordingly

Once you understand the concept of loss aversion, there are two steps you can take. The first is to try to best understand what loss feels like. The recent market movement can be a great case study. Did you experience the recent downturn and feel horrible? Did you log in to your account multiple times a day to check in? Did you lose sleep? These questions can offer hints as to how you're able to handle losses. Most importantly, keep in mind that this has been a pretty mild pullback – so far – especially in the context of the degree and duration of past gains. So if you lost a lot of equity in this decline, it could be an indication that you have too much risk in your portfolio.

Once you understand the degree of pain you'd feel over losses, act accordingly by adjusting your portfolio. The adjustments might be to add more fixed income or shift holdings from a cyclical industry into a defensive one.

The important point here is that in a lot of cases, investors are able to handle less risk than they think they can. Because of this, many may want to construct a portfolio more conservatively than they initially think they need. As they invest and become comfortable with all the different ways a market can move, they can then increase or decrease risk in the portfolio accordingly. It's been nearly three years since the last pullback in U.S. markets of 10 per cent or more; this one was not the first, and it will not be the last. Understanding yourself and others a bit better may make the next correction just a bit more bearable.

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