Smart investing in an uncertain stock market

By Richard Gore

Investing your hard-earned money in the stock market is, to some extent, a gamble. We buy stock, bonds or some other investment with the goal of increasing our wealth.

However, there is also the possibility of losing some or all of our investment. Compounding the issue is that the risk of loss is unknown and varies between alternative investments. For example, bonds are generally viewed as safer than stocks. This perception is likely because bonds provide a contractual promise to repay the face value of the security and they have performed well lately.

No such promise comes with an investment in shares of a company – the stock investor has no fixed date on which he or she will receive payment. In addition, stocks tend to fluctuate in price much more than bonds.

Therefore, many investors, particularly at this time, favor bonds instead of stocks for the certainty they appear to promise. However, it is unlikely that this desire for safety represents a completely rational investment decision.

In general, most people feel the pain of loss twice as much as they feel pleasure from an equal amount of gain. This phenomenon is known as loss or risk aversion and is a key insight of “prospect theory,” developed by Daniel Kahneman and Amos Tversky.

When faced with an equal chance to win $150 or lose $100, most people decline to bet even though the expected value of the bet is positive. The threat of losing $100 is more powerful than the possibility of winning $150.

Of course, the level of risk aversion varies by person and by the stakes involved. The principle is clear: “Losses loom larger than gains” for most people.

This pervasive and fundamental trait of human nature drives many investors to seek safety in bonds and shun stocks. On one hand, with interest rates at historical lows it may be that bonds are actually the riskier investment at this time because bond prices will fall when interest rates rise.

On the other hand, an investment in stocks might be advantageous at the moment. Given that humans are generally loss-adverse, stocks are likely to be systematically underpriced.

Indeed, loss aversion may be particularly strong now, after two recent stock market crashes. Thus, stocks should generally offer better long-term returns than bonds. Although bonds have outperformed stocks for the last 20 years, the future may well reverse this trend.

Although no one can predict future stock and bond prices, I believe a savvy investor can profit in the long run from human nature’s loss aversion by maintaining substantial allocation of investments in a diversified portfolio of stocks.

A general rule of thumb is to maintain an allocation of stocks in your investment portfolio of 100 minus your age. Hence, a 50-year-old should have 50 percent of the investment portfolio in stocks.

If you have been shunning stocks because of their volatility and an irrational fear of losses, you may want to reconsider your investment portfolio allocation. Investing should be done with an eye to the future, not the past. Richard Gore is associated professor of accounting at Fort Lewis College.