When equities fall sharply, it is only natural for investors to become concerned. Numerous studies have shown that humans have a psychological bias commonly known as loss aversion. Put simply, this principle is the idea that the pain of losing is psychologically about twice as powerful as the pleasure of gaining.
And not only are humans twice as likely to feel pain suffering a loss, but they are also much more likely to act dishonestly to avoid a loss.
Understanding the mental bias
All in all, loss aversion can be a very powerful psychological bias, and investors shouldn't beat themselves up if they feel affected by it. This bias affects everyone.
The easiest way to get around any mental bias is to understand it. This might seem like a very simplistic answer to a complex question, but just knowing that a psychological bias exists can be a considerable benefit in trying to avoid it and stop it from having an impact on decisions.
For example, investors who are aware of the drawbacks of loss avoidance can do everything in their power to try and avoid this psychological bias taking hold. One strategy may be avoiding looking at the market on days when it is falling.
Another strategy that could come in handy is to focus on the fundamentals. The operations of very few businesses are actually impacted by the day-to-day movements of the stock market. Some companies such as brokers and wealth managers might see a drop in client activity in a downturn, but this is really the only sector that is directly affected by equity markets.
As such, by focusing on the strengths of a business, it may be possible for investors to ignore and overcome the loss aversion bias by focusing on other more important factors.
I wanted to highlight a quote from Charlie Munger (Trades, Portfolio) which illustrates this principle. He made the following comments in 2009, that year's Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of shareholders. Munger said:
"I happen to know that there was one buyer there who rather inartistically bought about 10,000 shares when Berkshire was driven to its absolute peak. And how much significance does that have in the big scheme of things over the long term? What matters are things like this: our casualty insurance business is probably the best big casualty business in the world — our utility subsidiary, well, if there's a better one, I don't know it — and if I had to bet on one carbide cutting tool business in the world, I'd bet on ISCAR against any other comer. And I could go down the list a long way. I think those things are going to matter greatly over the long term. And if you think that it's easy to get in that kind of a position, the kind of position that Berkshire occupies, you are living in a different world from the one I inhabit."
Focus on the fundamentals
Munger was using Berkshire as an example in his statement, but this is applicable to many other businesses. The qualities that will matter for other companies include the strength of their network effects and competitive advantages. For example, Diageo (DEO, Financial) owns some of the world's most recognizable and valuable alcoholic beverage brands. This is the most crucial factor that will contribute to the company's success in the long run. Apple (AAPL, Financial), meanwhile, owns a valuable network infrastructure, which draws in consumers and links them to the products for years.
These qualities are what will matter in the long run, not the performance of the company's stock price over a few months or even years. To get around the psychological bias of loss of avoidance, it may be sensible to keep this in mind.