Kahneman and Tversky are also well-known for exploring the phenomenon of "loss aversion". Wikipedia sums up the phenomenon, saying "Loss aversion implies that one who loses $100 will lose more satisfaction than another person will gain satisfaction from a $100 windfall." Kahneman and Tversky came up with an ingenious set of experiments where they frame the same problem in different ways - in one case describing something as a potential loss and in another describing it as a potential gain - and found that people made different choices in the different situations even though there was no real economic difference between the two. When something was framed as a potential loss, people were more risk averse than when it was framed as a potential gain.
Part of the appeal of dollar-cost averaging is the fear that if we suddenly shift all our money into stocks, the market could tumble tomorrow and we would lose a lot of money. However, it could equally well be pointed out that the market could skyrocket tomorrow, and we could end up with a lot more money than we would have with dollar-cost averaging. Since our current portfolio with the money in cash is regarded as the baseline, the first scenario is regarded as a loss and the second scenario is regarded as a gain. So loss aversion could be the explanation of why we don't treat the two possibilities symmetrically and why the potential scenario of the market dropping tomorrow is unduly influential.
Saturday, September 13, 2008
Saturday, September 6, 2008
The Psychology of Dollar-Cost Averaging, Part One
Continuing on the topic of dollar-cost averaging, I have some theories about the psychological factors that make dollar-cost averaging appealing. It may be helpful to consider an analogy. Suppose we are contemplating walking up to the edge of a very high and steep cliff in windy weather. Rather than just striding directly to the edge, you would probably approach slowly, testing your footing at each step. This slow approach to the precipice is the analog to dollar-cost averaging. We gradually transition from a safer position (standing back from the edge, or holding a sum of money in cash) to a riskier position (standing right on the edge, or putting all of that sum of money in stocks). This gradual transitioning makes sense in the context of approaching the edge of a cliff. However, as I will show, this situation is not analogous to the financial case in the crucial respects.
In the case of approaching the edge of a cliff, the risks are somewhat unknown. We may not know how stable the footing is, how strong the winds are, or how disoriented we will become by the prospect of the sheer drop. In the face of such uncertainty, it makes sense to gradually ramp up the risk, turning back if the riskiness exceeds our tolerance. At each step, we reassess - we test our footing, we see if we can maintain an upright posture and a sense of balance - and we gain new information about how safe we are. It is this uncertainty about the true riskiness - and the ability to reassess it at each step - that makes the gradual transitioning process rational.
The financial situation is quite different. To begin with, you cannot accurately assess the riskiness of holding stocks by observing the market for a month. Over a one-month period, the market may perform much better than expectation or much worse than expectation. It may be much more volatile than normal, or much less. One month, or even a year, is not really enough to learn anything. So the element of learning something as you "approach the precipice" gradually is not present here.
In general, the way to gauge the riskiness of stocks (or any other asset class) is by looking at their behavior over a long period of time. For example, we might look at their performance and volatility over the past 100 years. Once we have done so, we have essentially all the information we are going to have regarding their riskiness. Another one month of observation is not going to add much value. So, unlike the cliff example, the riskiness is known in advance (to the extent that it is knowable) and there is no information to be gained by the gradual transitioning.
I should acknowledge that dollar-cost averaging may be rational for some based on psychological considerations. For example, suppose you don't know how well you will sleep at night, after you invest your money in the market, given the substantial volatility of stocks. In this case, you cannot quantify your gains or losses in purely dollar terms - you are also concerned about the effects on your mental health, which may not be knowable until you experience the daily swings "first hand". In such a case, it may be rational to enter the market gradually, reassessing your mental state as you go. Even so, it still needs to be said that this process may give you a false sense of confidence in that the market may not experience a major correction during the period in which you are performing the transition.
But, more generally, for the investor who will not be anguished by losses - or who can assess and account for such psychological considerations in advance - dollar-cost averaging offers no real advantages.
This kind of irrationality is the sort of thing people in Behavioral Economics study. Some readers may be familiar with the work of Kahneman and Tversky which, as I understand it, was the inspiration and foundation for this field. It would be interesting to know if anyone working within Behavioral Economics has studied why dollar-cost averaging appeals to people.
In the case of approaching the edge of a cliff, the risks are somewhat unknown. We may not know how stable the footing is, how strong the winds are, or how disoriented we will become by the prospect of the sheer drop. In the face of such uncertainty, it makes sense to gradually ramp up the risk, turning back if the riskiness exceeds our tolerance. At each step, we reassess - we test our footing, we see if we can maintain an upright posture and a sense of balance - and we gain new information about how safe we are. It is this uncertainty about the true riskiness - and the ability to reassess it at each step - that makes the gradual transitioning process rational.
The financial situation is quite different. To begin with, you cannot accurately assess the riskiness of holding stocks by observing the market for a month. Over a one-month period, the market may perform much better than expectation or much worse than expectation. It may be much more volatile than normal, or much less. One month, or even a year, is not really enough to learn anything. So the element of learning something as you "approach the precipice" gradually is not present here.
In general, the way to gauge the riskiness of stocks (or any other asset class) is by looking at their behavior over a long period of time. For example, we might look at their performance and volatility over the past 100 years. Once we have done so, we have essentially all the information we are going to have regarding their riskiness. Another one month of observation is not going to add much value. So, unlike the cliff example, the riskiness is known in advance (to the extent that it is knowable) and there is no information to be gained by the gradual transitioning.
I should acknowledge that dollar-cost averaging may be rational for some based on psychological considerations. For example, suppose you don't know how well you will sleep at night, after you invest your money in the market, given the substantial volatility of stocks. In this case, you cannot quantify your gains or losses in purely dollar terms - you are also concerned about the effects on your mental health, which may not be knowable until you experience the daily swings "first hand". In such a case, it may be rational to enter the market gradually, reassessing your mental state as you go. Even so, it still needs to be said that this process may give you a false sense of confidence in that the market may not experience a major correction during the period in which you are performing the transition.
But, more generally, for the investor who will not be anguished by losses - or who can assess and account for such psychological considerations in advance - dollar-cost averaging offers no real advantages.
This kind of irrationality is the sort of thing people in Behavioral Economics study. Some readers may be familiar with the work of Kahneman and Tversky which, as I understand it, was the inspiration and foundation for this field. It would be interesting to know if anyone working within Behavioral Economics has studied why dollar-cost averaging appeals to people.
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