Why Losses Hurt So Much More Than Gains Help

In the year 2020, those of us in the market experienced a wild roller coaster ride of losses and gains. The constant swing between the pain of loss and the pleasure of gain. The question is, though, why do losses hurt so much more than the pleasure we get from gains? There are two main reasons.

The first is simple arithmetic, a 50% loss takes a 100% gain just to break even. Although you may assume a 50% loss would take a 50% gain to equalize, that’s not the case. Let’s break it down further, a 50% loss on $20 is $10. A 50% gain on  $10 is $5. The total is only $15, you lost $5. So, you need a 100% gain on the $10 to get back to your original $20.

Losses also hurt more since the majority of us naturally loss-averse. Indeed, experts say the pain of a loss is twice as powerful as the pleasure of a gain. As a result, we engage in a lot of (sometimes) counterproductive behavior to avoid the pain of loss. Although this pain/pleasure analysis may be more complicated than originally thought, we still hate to lose. Not only is there the emotional pain, but the simple arithmetic of making up losses is equally painful.

So what can you do? You can find ways to reduce risk while still looking to achieve gains.

Be the house, not the gambler

You may be thinking, “If I take big risks, then I could get big rewards.” While that may be true, you aren’t guaranteed that win. More often than not, in fact, you won’t get that win. Take this scenario as an example.

Think of yourself as a casino rather than a bettor. A typical gambler will risk bigger and bigger bets while chasing losses at the tables. Investors, too, will often chase their losses and hold on to failing investments, waiting for them to come back. Both of them would do better by being the house to take the least amount of risk to get consistent return.

A casino knows that it will never experience a dramatic win, but it will consistently, day in and day out, make money on every bet that is placed (ranging from a low 0.5% on video poker to a whopping 30% on Keno). That so-called house advantage, essentially the price you pay to play the game, comes in on every bet placed, allowing the house to make lots of small, consistent profits instead of seeking one exciting windfall. A smart investor also seeks this kind of steady return instead of chasing that one Microsoft IPO stroke of luck.

Get professional help

Leveraging a professional financial advisor could potentially help you reduce the amount of risk. But not all financial advisors help you in the same capacity.   So, what kind of investment professional should you use?

Who are the professionals?

Essentially, there are two types of investment professionals who work with individual investors: registered representatives (RRs) of broker-dealers and investment advisory representatives (IARs) of registered investment advisors. RRs are compensated on transaction-based commissions (that is, they only get paid when they sell you something), and they are governed by the SEC’s Best Interest Rule. IARs are compensated through a flat fee based on the assets under management and are, by law, fiduciaries to their clients.

The differences are subtle, but the SEC has gone to great lengths to help clarify the difference. In essence, an RR must have your best interest in mind when they make a transaction recommendation, while an IAR always has a fiduciary duty to act in your best interests only.

What will they recommend?

An RR will sometimes face pressure to sell you products as their firm directs and, in any case, can only sell you products actually offered by that firm. An IAR, on the other hand, has virtually the entire universe of investments available for use and can thus focus solely on your interests rather than on what a big firm might want them to sell.

A fee-based fiduciary IAR working in your best interests, like Financial & Tax Architects, will get to know your financial goals and objectives, help you figure out how much income you will need in retirement, and help you structure your assets and income to best meet those goals. They will not focus on selling you a product but on serving your needs, which will help you take the least amount of risk to get the highest return.

In the end, the IAR will, in consultation with you, create and help you maintain a detailed financial plan, taking you through the accumulation phase of your investments into planning for the period when you will rely on that income for maintaining your life in retirement.

Consider creating your own private pension

One other tactic you can take in fine-tuning your retirement plan with your investment professional is to create a private pension for yourself. You can do this by buying an annuity specifically designed to provide the income you need to achieve and maintain your financial goals.

Annuities have a bad name, and many advisors hate them. However, an annuity, like a pension, is a contract purchased to provide a given stream of income. There are fixed annuities, variable annuities and, most recently, indexed annuities. In today’s interest environment, fixed annuities provide low returns for high fees while variable annuities put your money in the market like a mutual fund, but do it at a higher cost.

Indexed annuities, when properly constructed and focused on your needs, can provide income that tracks a market index without putting your money at risk in that market. Working with an advisor who really understands this kind of annuity, such as Financial & Tax Architects, can allow you to create one or more private pensions to keep your post-retirement income at the levels you need to live your desired lifestyle.

In other words, be the house

In the end, your best bet is to be the house, not the gambler. Take the least amount of risk to get the highest return. Professional advice is crucial to achieving this, so reach out to the experts at Financial & Tax Architects to get started.