Investment: don’t confuse loss, pain and uncertainty

Many investors prefer to avoid recognising a loss in their portfolio – they do nothing in the hope that their shares will start to rise again. This may spare them the pain associated with the loss but it burdens them with the stress related to the uncertainty. This is a very bad trade!

Do you tend to postpone the moment of truth when you find out whether an investment has been a top pick or a flop? If that’s the case, this article should give you food for thought. The research is very clear: in psychological terms, it is less painful and more beneficial to come to terms with reality and accept a loss rather than extending a period of uncertainty. Facing reality also reduces our fear of the unknown and allows us to benefit from the opportunities it affords.

Harness your stress

All – or almost all – investors have at some point refused to come to terms with reality, postponing the moment when they recognise a loss on a poor investment. For one simple reason: to avoid the psychological pain that comes on top of the financial loss. But this approach subjects them to the stress of worrying about potentially having to deal with an identical or even worse situation at some point in the future. This is worse than trying to accept the reality of the situation. This small experiment should convince you of this.

Imagine a virtual game where players have to predict whether a snake is hiding under the stones that must be turned over one by one. The players are split into two groups.

• • Group 1: if the player fails to predict where the snake is, they know that they have a 50% chance of receiving a small electric shock and a 50% chance of no consequences.
  • Group 2: if the player fails to predict where the snake is, they know that they have a 100% chance of receiving a stronger electric shock, which means having to deal with a very unpleasant situation.

In your opinion, which group in the experiment experienced the highest stress levels? Contrary to what one might assume, Group 1, which was exposed to greater uncertainty, experienced the highest stress levels. This has been illustrated by a very serious study carried out by the Institute of Neurology of University College London (UCL). Being certain that you will receive an electric shock if you are wrong is less stressful in psychological terms than uncertainty.

It turns out that it is worse not knowing whether you will receive a shock than being certain that you will.

The main author of this study made the following comment on these results: “Our experiment allows us to draw conclusions about the effect of uncertainty on stress. It turns out that it’s much worse not knowing you are going to get a shock than knowing you definitely will or won’t.”

Whilst this study was the first to quantify the impact of uncertainty on stress, the principle is understandable and easily explained: uncertainty makes us anxious. Just think about waiting for the results of medical tests, looking for information on train delays or the performance of our investment portfolio after an unexpected financial shock.

Is this anxiety necessarily a bad thing? Not really. This stress is a mechanism inherited from our evolutionary past, which can help us adapt better to our uncertain environment. In the experiment cited above, those who experienced the highest stress levels due to the uncertainty of not knowing whether they would receive a shock were ultimately the ones who, over time, were the best at learning how to predict where the snake could be in the game! For one simple reason: those who experience the most “pain” are the most motivated to advance and find a way to reduce it.

Weathering the storm

What lessons can be drawn from this experiment for investors who refuse to come to terms with the reality of their situation and recognise their losses. Investors undoubtedly postpone the fatal moment for fear of the pain that will be caused by the loss. This pain felt in response to a loss is due to the loss aversion that we inherited from our ancestors. The psychological pain that we feel in this precise situation is of the same kind, from a neurological perspective, as that felt from physical pain.

In light of the cited experiment, we can understand that this type of behaviour is not helpful. An investor who undoubtedly believes that they are protecting themselves by remaining in uncertainty is actually amplifying their stress levels and pain by behaving like an ostrich. More serious still, they are delaying the urgent decisions that are needed regarding their investments.

Investors sometimes torture themselves unnecessarily by confusing risk and uncertainty!

Passivity is certainly the most damaging reaction that investors can adopt when faced with the unknown. So why do they resort to these tactics so often? Perhaps refusing at all costs to come to terms with a loss is also related to a feeling of guilt associated with the fact that the risks were wrongly assessed from the outset. However, investors are committing another error here and torturing themselves unnecessarily by confusing risk and uncertainty!

Risk and uncertainty

Many investors confuse risk and uncertainty. Risk can be estimated by statistical observation (correlation and the standard deviation of returns) and described by probability distributions, whether we are talking about the probability of winning or losing at roulette or the risks involved in taking a plane under normal conditions. The world of investment is less a world governed by risk than a world made up of uncertainty!

While there are of course a whole series of objective parameters to consider prior to taking an investment decision, we must be aware that investing is always a bet on the future. And the problem with the future is that it usually difficult to predict. Professional investors do their best to assess and predict what will happen but, ultimately, they always invest in unknown and uncertain environments. They have the expertise to minimise risk but they are not clairvoyant and cannot reduce the uncertainty. This is one of the reasons why investors should remain humble, diversify their investments and adopt a long-term approach.

Note that we are not claiming that investment is simply a game of chance. Traditional financial theories work rather well at quantifying risk in normal environments, but they collapse in extreme situations. None of these theories are able to predict a pandemic and its consequences for markets. Economic theory does not solve the issue of uncertainty.

The best decision in a high-risk situation is not the best decision in an uncertain situation.

With uncertainty, everything is open. The outcome can be neither known nor calculated. The best decision in a high-risk situation is not the best decision in an uncertain situation. So what can we do if we can’t predict uncertainty? The best option is to be prepared for extreme situations so that we are able to navigate the choppy waters when the storm hits.

Prepare for the worst, hope for the best and be patient

An uncertain future cannot, by definition, be predicted. However, it is possible to be prepared for dealing with it. The first stage of this preparation is to accept that uncertain situations will arise. Behaving like an ostrich and sticking your head in the sand is not a solution.

The second stage is to analyse your current portfolio and investment strategy in light of this uncertainty. While we are unable to predict the causes and extent of extreme events, it is possible to work together with your bank adviser to include a failure scenario in an investment strategy and then study the options available for minimising any potential losses. The basic aim is to carefully select assets that will hold up well in various scenarios, and to gain a better understanding of the investments you hold. This does not resolve the issue of uncertainty but it gives you the tools to manage your emotions in the event of a crisis and to rapidly return to logical reasoning based on a long-term approach.

Get help with designing different scenarios so that you can carry out a virtual test on the impact of various shocks on your portfolio and figure out the level of pain you can bear. An expert can help you work out various shock scenarios and advise on the best split of assets to offset these.

The third stage is to keep a cool head and adopt a positive attitude when faced with uncertainty. An extreme event may sometimes be a source of investment opportunities. Furthermore, a crisis or an extreme market movement rarely lasts for a long time. So once the short-term turbulence subsides, your long-term investment objective is key. Don’t lose sight of this.

Your goal is to protect and, over time, grow the overall value of your portfolio, so don’t focus on the number of failures suffered along the way, but on the extent of your total losses or gains over the long term. Investors whose aim is to avoid losses at all costs often sacrifice a major portion of potential growth. Investors who are able to bear an occasional loss and stay on track are those who will be able to take advantage of any opportunities that may arise.

Investors whose aim is to avoid losses at all costs often sacrifice a major portion of potential growth.

The main thing is to accept uncertainty, prepare for it and deal with it calmly. This is a prerequisite for successful investing. The aim is not to eliminate uncertainty but to accept it and manage it. If you accept uncertainty, it stops being a situation to be afraid of and becomes an opportunity to exploit. As a bonus, you will avoid the serious stress that is more “painful” than the pain felt when recognising your current losses. Otherwise, this type of stress may result in you making the wrong decisions or being unable to make any decisions at all, at times when inaction may have dramatic consequences.