For equity investors, the pain of a loss seems to be stronger than the pleasure of investment gains. The financial crisis ended many years ago, yet three out of four investors remain wary of stocks. A behavioral trap called risk aversion may be contributing to investors' negative attitudes toward stocks.
According to a recent survey conducted by Bankrate.com, 73% of investors indicated that stocks were of no interest to them. Instead, these investors preferred to put their money in conservative, low-yielding investments such as CDs, money market funds, government bonds, and savings accounts.
Investors who shunned stocks in favor of ultra-conservative investments during the past few years missed out on significant gains. For example, those who invested in three-month T-Bills instead of stocks during the past five years received an average annual total return of 0.11% vs. 19.14% for the S&P 500 Index.
Source: Hartford Funds.
Investors' hesitation to invest in stocks may have to do with losses they experienced during the financial crisis of 2008 and memories of the tech bubble bursting in 2000. According to a study done in the U.K., exposure to economic turmoil dampens people's appetite for risk. The study showed that a decade after the period of economic hardship, subjects in the study were less likely to own stocks.
Other studies on risk aversion also provide insight into how emotions can interfere with decision-making. An experiment conducted by researchers at Carnegie Mellon University concluded that negative emotions resulting from loss can lead people to avoid taking risk. In this experiment, there were two groups of subjects. The first group suffered damage to the part of the brain that governs emotion. The second group was healthy. Both groups were asked to play a game that gave them the chance to make money betting on a series of coin tosses. Subjects could either choose to either bet before each coin toss, or not. Heads, they'd lose $1.00; tails, they'd win $2.50.
Clearly, the game was set up to provide an advantage for those who bet on every single toss. However, after betting and losing money on a coin toss, only 40% of the healthy subjects bet on the next toss. By contrast, only 85% of the emotionally impaired subjects continued to bet. In the end, the emotionally impaired subjects won more money than the healthy subjects.
Risk-averse investors who prefer conservative investments such as government bonds instead of stocks need to understand the ramifications of their decision. If their investments do not keep pace with inflation, they may not be able to meet their savings goals. For instance, those who are saving toward future healthcare costs or higher education costs - both of which are rising faster than the rate of inflation - may find that government bonds do not offer sufficient growth potential.
Those who understand the existence of behavioral traps such as risk aversion can take steps to try to avoid them. One of the easiest ways for investors to overcome risk aversion is to seek help from a knowledgeable financial advisor. A financial advisor can provide clarity and perspective when emotions threaten to get in the way of investment success.
All investments are subject to risk, including the possible loss of principal. Unlike stocks and bonds, U.S. Treasury securities are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. Past performance is no guarantee of future results. Indices are unmanaged and not available for direct investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The article has been written by Hartford Funds' Investment Team. Hartford Funds is not receiving compensation for it. Hartford Funds has no business relationship with any company whose stock is mentioned in this article.