How (not) to be miserable

The other day I asked how happy one might become by making an investment that grew 3.6 times over ten years. Or to be more precise, would keeping track of your investment daily make you happy?

The answer, apparently, is that you’d be miserable.

It comes down to loss aversion and the asymmetry in our mental accounting between wins and losses. In short, the pain from a loss is greater than the satisfaction from a win. About three times more. (I presume this depends upon the natural disposition of the individual?) This means that my pleasure from winning $30 is equal but opposite to the pain I receive from losing $10.

There’s also an element of diminishing returns. Winning or losing $2000 isn’t twice as good/bad as $1000.

With this in mind I’ve simulated the returns and likely happiness of an individual based on the NZX50 for the past ten years. Of course, this is over-simplistic (feedback mechanisms and learning may distort things over time), but it does lead us to some interesting thoughts…

1. Loss aversion can play havoc with our emotions. Even when it’s quite irrational.
2. We’re better off taking a long-term view of things. Checking one’s investment annually would be much less demoralising.
3. When investments are performing well, it’s better to compare performance with respect to the base (Day 0) than the previous day. This is why, when making changes in our lives, we’re advised to compare ourselves to how we were a year ago.
4. If we take Point 1. further, our irrationality (emotional upset as a result of financial gain) could lead to behaviour that is far from optimal (avoiding a good investment to minimise emotional pain).
5. In many ways, society benefits from individuals engaging in rational yet risky behaviour (even though the individual may not). Loss aversion probably limits societal gains yet minimises personal risk.

What could we do with this knowledge?

• Avoid reporting business performance too frequently (especially to easily demoralised employees)
• Measure performance against a benchmark, not inter-period change (never compare today’s weight with yesterday’s weight, compare instead with when you began your diet)
• Consider an alternative ‘human centric’ measure that is emotionally neutral (for select audiences only, not for accounts!)

If you find this sort of thing interesting, then you might enjoy Taleb and Kahneman.