How I learnt to lose

Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest.

 I did a wine tasting game for a friend’s birthday last weekend. Six anonymous wines, six descriptions and a rather flamboyant sommelier herding five increasingly confident teams.

After all the swilling and swirling I ended up matching a measly two out of six, with the group on the end getting every single one right. A bit of fun but what surprised me was how disappointed I was, especially given how hopeless I knew I would be even before we started.

It’s amazing how we prepare for and respond to losing particularly, as in my case, when the end result isn’t that important and we really are no worse off at all. Thanks to the work of the likes of economists Richard Thaler and Daniel Kahneman we now know that we experience the pain of a loss twice as much as the joy of a gain, so the distress we feel at the thought of the former means we’re only human, even if it is only mistaking the picpoul for the chardonnay.

Why losing hurts

Loss aversion is a natural evolutionary trait - not fancying our chances against certain climates, angry animals and sketchy terrain gave humans the chance to survive, so being cautious has served us well.

However, when we think like this for too long we forget that the sensible risk involved in hunting, agriculture and migration has been equally as valuable. The key here is to weigh up the risk-reward ratio and make sure we’re ok with the outcome, whatever happens - before it happens.

The best investors have a similar attitude, accepting that loss can and does happen, but that sensible risk in a robust diversified portfolio in the background is likely to pick up the slack and make up for losses over the long-term. In fact, even the best professional fund managers often only get just over 50% of their decisions right - the skill is in running your winners and dealing with a loss when it comes around.

Unsurprisingly, panic and inertia aren’t ideal in these situations but they are a couple of the most common reactions among the rest of us. Lee Freeman-Shor’s book The Art of Execution puts it plainly - if a fund or share price drops we should either decide it no longer holds the long-term attraction it once did and sell, or decide it still does and buy more shares or units at the new lower price, like shopping in the sales. The only useless reaction is to stay stuck in the headlights.

Remember, market ups and downs are the price we pay for the long-term outperformance of equities over cash. Keeping that long-term view at the front of your mind should help you look at short-term fluctuations as nothing more than mere blips on a much longer journey.

Invest, just not emotionally

Another reason a loss can hit us hard is if we have grown attached to a certain investment. Losing money on a coin toss might sting but when we’ve put time and effort into choosing a certain fund or share and it drops it can feel a lot more personal. Be careful not to fall into the Ikea-bias trap here - just because you made a coffee table or chose it does not make it any better or more valuable than the next one.

Our investments are a lot more important than wine tasting but if we can spot our natural reactions to winning and losing in other areas of our lives, we can begin to recognise them and confront them when our portfolios move.

In my case, I really had lost nothing in the grand scheme of things, and for investors that’s normally the case too. If you have a good mix of funds in your portfolio, that downward-pointing line graph will often be a short-term thing. The best days in the market regularly follow the worst and it’s about being ready for both without reacting rashly either way.

Adequately diversifying your portfolio with a range of assets is a basic principle of long-term investing. If the environment changes, it’ll be too late to start chopping and changing so get it sorted beforehand to make sure some cylinders are firing at all times.