A couple of weeks ago on the heels of a CFA Society of St. Louis Luncheon with BlackRock's Benjamin Kelly, I wrote about cutting out a layer of behavioral bias with the use of index funds (or index-based ETFs). Today, we'll begin to look at some of these biases by introducing the concept of Loss Aversion.

Consider two sets of choices:

CHOICE 1

You can pick between:

A: A 100% chance of receiving $15,000 -or-

B: A 20% chance of receiving nothing and an 80% chance of receiving $20,000

Go ahead and make your choice and write it down.

CHOICE 2

You can pick between:

A: A 100% chance of losing $15,000 -or-

B: A 20% chance of losing nothing and an 80% chance of losing $20,000

Write that choice down.

MODERN PORTFOLIO THEORY vs BEHAVIORAL FINANCE

Modern portfolio theory, the underpinning of finance for years, assumes that people are risk averse, that is, given the same expected return, people will choose the less risky option. In fact, what behavioral finance has discovered is that many people are loss averse. What's the difference? Let's look at the two choices above:

In CHOICE 1, the expected return of option B is 0.80 * $20,000, or $16,000 - more than option A. If you're extremely risk averse, you may pick the 'sure thing' of option A. If you are risk neutral, you'll pick option B due to its higher expected payout.

A funny thing happens when you look at CHOICE 2 though. Here we are talking about losing money, not gaining. If you look at it closely, it's the same problem in reverse. Here though, many of the most risk averse individuals will not take a sure loss even though picking option B is both riskier and has a worse expected income. Investors get anchored to their current level of wealth and as a result, losses hurt much worse than the satisfaction you get from a similar upside gain.

How does this manifest itself in investing? If you (or your portfolio manager) pick individual stocks, you are more likely to sell winners to 'lock in gains' and hold losers too long in hopes they will 'bounce back'. Capital-weighted index funds (like S&P 500) avoid this because as the stock price grows, so does the stock's weight in the index.

In the next few weeks we'll look at some other biases, such as overconfidence.