We are pleased to offer our readers a guest post by Meir Statman who is the Glenn Klimek Professor of Finance at Santa Clara University.  His research focuses on behavioral finance and how investor decision making ultimately affects financial markets.  He is also the author of the newly published book, What Investors Really Want:  Discover What Drives Investor Behavior and Make Smarter Financial Decisions.  The following post on the attraction of no-mental loss investments is drawn from Chapter 10 of his book that focuses on our individual desire to avoid losses.

The attraction of no-mental-loss investments – Meir Statman

Some investments give us options to obscure losses or postpone their realization. We frame them as “no-mental-loss” investments. The realistic selling price of a particular house is the $200,000 price it would fetch from today’s buyers. That realistic price might well be lower than the $300,000 we paid for it five years ago. When we sell this house at its realistic price we realize a $100,000 loss. Yet we can frame this house as a no-mental-loss investment in two ways. First, we can postpone selling our house. Second, we can obscure our loss by avoiding any information pointing to it. We can avoid looking at the zillow.com Web site, which estimates the value of our house at $200,000. We can avoid hearing the story of our neighbor who just sold an identical house for $200,000.

Framing investments as no-mental-loss investments is not all bad. We feel better when we see ourselves as winners rather than as losers. But framing investments as no-mental-loss investments is bad if it leads us into stupid decisions. Terrific job opportunities might await us in other cities. It is stupid not to pursue them because we are reluctant to sell our houses at a loss.

We are pretty good at framing investments as no-mental-loss investments. We are pretty good at avoiding information about investment losses, sparing us the regret that accompanies facing them. Bradford Roth, a Chicago lawyer, came into a Fidelity Investments branch to make a deposit to his checking account following a major decline in the stock market in 2008, but he did not check the balance of his retirement account. “The less you know,” he said, “the better you feel.”

Many investors in the United States, Israel, and Sweden follow Roth’s method. Swedish investors are more likely to look up the balances of their portfolios on days when they know from general news that the stock market went up than on days when they know that the market went down. This way they savor the pride of portfolio gains while shielding themselves from the regret of portfolio losses by pretending that the general decline in the stock market was accompanied by no losses in their own portfolios. Israeli investors prefer certificates of deposit issued by banks over Treasury bills, even though Treasury bills offer higher returns. They do so because certificates of deposit display no daily prices, making it easier for investors to keep themselves blind to losses. Investors in Treasury bills find it harder to keep themselves blind to losses because daily prices of Treasury bills are displayed in newspapers and on the Internet.

Zero-coupon Treasury bonds can easily be framed as no-mental-loss investments. Zero-coupon Treasury bonds pay no interest. Instead, we buy them at a discount. For example, we might buy a zero-coupon Treasury bond maturing in 20 years for $45,000. The bond promises to pay us $100,000 when it matures, but its price might go higher or lower than $45,000 during its years, depending on changes in interest rates. The no-mental-loss benefits of zero-coupon Treasury bonds are reflected in their description as safety nets with the bounce of a trampoline. If the price of the bond exceeds $45,000 a year or two later, we can realize a gain, enjoying the bounce of a trampoline. But we can pretend that we have sustained no loss if the price of the bond declined to $35,000 a year or two later, since we do not have to realize our loss and have a safety net in the $100,000 we are sure to receive in 20 years.

We hear the importance of the expressive and emotional benefits of no-mental-loss investments in comments about the advantage of buying individual Treasury bonds over mutual funds containing Treasury bonds. Individual bonds have specific maturity dates, such as in three years, while bond mutual funds contain many bonds with varying maturity dates, perhaps some with two years to maturity, some with three, and some with four. Holders of individual bonds have greater no-mental-loss benefits than holders of bond mutual funds since they have the option to wait till the maturity date of each of their individual bonds and receive what they have been promised. In contrast, holders of bond mutual funds have no such option since mutual funds have no maturity dates. The prices of mutual funds are set at the market price at the end of each day, moving up or down. Holders of bond mutual funds are never assured that they will not incur a loss when they sell, no matter how long they wait.

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