By Simon Bond

Having been in the stockbroking business for such a significant period of time it never ceases to amaze me just how many people need to be saved from themselves.

Investors not just in Australia but globally clearly have a fundamental misunderstanding of risk. How do we define risk? In finance risk is: The probability that an actual return on an investment will be lower than the expected return. Financial risk is divided into the following categories: Basic risk, Capital risk, Country risk, Default risk, Delivery risk, Economic risk, Exchange rate risk, Interest rate risk, Liquidity risk, Operations risk, Payment system risk, Political risk, Refinancing risk, Reinvestment risk, Settlement risk, Sovereign risk, and Underwriting risk.

Investors and potential investors come to visit our offices with all sorts of different investment strategies. When we sit down with them the first thing we ask is whether they understand than an investment in the stock market involves an element of risk, and, there is a chance that an investment in shares may result in the investor losing some, or in some cases even all of their money depending on the nature of the business. 

This is usually not music to their ears, people want to be told exactly the opposite. However studies have shown that (according to Wikipedia) in economics and decision theory, loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains. 

Most studies suggest that losses are twice as powerful, psychologically, as gains. Loss aversion was first demonstrated by Amos Tversky and Daniel Kahneman.

This leads to risk aversion when people evaluate an outcome comprising similar gains and losses; since people prefer avoiding losses to making gains.

Loss aversion implies that one who loses $100 will lose more satisfaction than another person will gain satisfaction from a $100 windfall. In marketing, the use of trial periods and rebates tries to take advantage of the buyer's tendency to value the good more after the buyer incorporates it in the status quo.

Note that whether a transaction is framed as a loss or as a gain is very important to this calculation: would you rather get a $5 discount, or avoid a $5 surcharge? The same change in price framed differently has a significant effect on consumer behaviour. Though traditional economists consider this "endowment effect" and all other effects of loss aversion to be completely irrational, that is why it is so important to the fields of marketing and behavioural finance. The effect of loss aversion in a marketing setting was demonstrated in a study of consumer reaction to price changes to insurance policies. The study found price increases had twice the effect on customer switching, compared to price decreases.

Back to the stock market; in these times of increased uncertainty and volatility, instant on, and share price change alerts every time there is an uptick or downtick in the price this leads investors to a very short term way of thought and risk taking. After all you can’t look up the price of your house every hour of every day like you can in the stock market.

So what to do; well it is my considered opinion that there are many market investors who simply have no business being invested in shares. There is just too much risk and in a low interest rate environment where negative interest rates are now the norm in many countries the challenges are amplified as investors run from place to place in search of better than zero returns.

My advice is to back the people, back the business not the stock price. As the founders of Google like to explain to potential investors, “A management team distracted by a series of short term targets is a pointless as a dieter stepping on a scale every half hour”.

There are great companies out there to invest in, investors just need to understand it takes more than five minutes to build a sustainable business.