The Psychology of Dollar-Cost Averaging, Part Two

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.