The Pleasure/Pain Principle

The financial crisis of 2008-2009 was painful, not to mention the Flash Crash of 2010; the Debt Ceiling / Credit Downgrade of 2011; and the never-ending European saga. Needless to say, these and other events have caused pain akin to burning one’s hand on the stove. This unpleasant effect has rubbed off on investors.

Admitting one has a problem is half the battle of conquering a challenge.  A key challenge for many investors is understanding the crippling effects fear can have on personal investment decisions. While there are certainly investors who constantly see financial markets through rose-colored glasses (my glasses I argue are only slightly tinted), Nobel Prize winner Daniel Kahneman and his partner Amos Tversky understand the pain of losses can be twice as painful as the pleasure experienced through gains (see diagram below).

Said a little differently, faced with sure gain, most investors are risk-averse, but faced with sure loss, investors prefer risk-taking. Don’t believe me? Well, let’s take a look at some of Kahneman and Tversky’s behavioral finance work on what they called “Prospect Theory” (1979) – the analysis of decisions made under various risk scenarios.

In one specific experiment, Kahneman and Tversky presented groups of subjects with a number of problems. One group of subjects was presented with this problem:

Problem #1: In addition to whatever you own, you have been given $1,000. You are now asked to choose between:

A. A sure gain of $500

B. A 50% change to gain $1,000 and a 50% chance to gain nothing.

Another group of subjects was presented with this problem:

Problem #2:  In addition to whatever you own, you have been given $2,000. You are now asked to choose between:

A. A sure loss of $500

B. A 50% chance to lose $1,000 and a 50% chance to lose nothing.

In the first group, 84% of the respondents chose A and in the second group, 69% of the respondents chose B. Both problems are identical in terms of the net cash outcomes ($1,500 for Answer A, and 50% chance of $1,000 or $2,000 for Answer B). Nonetheless, due the different “loss phrasing” in each question, Answer A sounds more appealing in Question #1, and Answer B sounds more appealing in Question #2. The results are irrational, but investors have been known to be illogical too.

In practical trading terms, the application of “Prospect Theory” often manifests itself via the pain principle. Due to loss aversion, investors tend to cash in gains too early and fail to allow their winning stocks to run higher for a long enough period.

The framing of the Kahneman and Tversky’s questions is no different than the framing of political and economic issues by the various media outlets (seePessimism Porn). Fear can generate advertising revenue and fear can also push investors into paralysis (see the equity fund flow data in Fund Flows Paradox).

Greed can sell in the financial markets too. The main sources of financial market greed have been primarily limited to bonds, cash, and gold. If you caught those trends early enough, you are happy as a clam, but like most things in life, nothing lasts forever. The same principle applies to financial markets, and over time, capital in today’s winners will slowly transition into today’s losers (i.e., tomorrow’s winners).

A healthy amount of fear is healthy, but correctly understanding the dynamics of the “Pleasure/Pain Principle” can turn those fearful tears into profitable pleasure.

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Buffett & Munger on Gold

This morning on CNBC, Warren Buffett offered his views on gold.

According to him, productive assets (and maybe even caves) have an advantage over the yellow metal.

As he has said on earlier occasions, Buffett believes since gold is not a productive asset that, over the long haul, it will not do as well as productive assets like farmland and stocks.*

Buffett added that gold buyers have it right to be concerned about the future value of paper money, but he thinks the strategy of buying gold to protect against that decline is the wrong one. From this CNBC article:

They have a "correct basic premise" that paper money will be worth less in coming years. 

He disagrees with them on the strategy of buying gold to avoid that decline in value. 

Buffett later added... 

"They want everybody to be so scared they run to a cave with gold. Caves might be a better investment than gold. At least they're not producing new caves all the time." 

Charlie Munger believes civilized people don't buy the yellow metal. In this separate interview on CNBC, he added:

"...I think civilized people don't buy gold, they invest in productive businesses."

It's certainly not at all wrong to expect that paper money will go down in value. In fact, paper money almost certainly will go down in value over time, much as it has been doing this past century or so.
(and, well, pretty much throughout financial history.)

It's just that the right productive assets (durable competitive advantages, capable management, conservatively financed) bought at the right price (comfortable margin of safety), at least in the long run, offer a fine way to protect against that seemingly inevitable decline in paper money, Well, at least for the investor with discipline, who can judge value well, and control emotions during market highs and lows.

Now, let's say gold does in the long run, in fact, perform better than the paper currencies (as it very well may).

To me, that's equivalent to voluntarily choosing to be the passenger of one of two sinking ships when there's a more seaworthy long-term alternative.

Best case, the satisfaction comes from having chosen the sinking ship that, under certain conditions, seems to be remaining afloat but may actually also taking on water, albeit more slowly.

The more seaworthy alternative, that being well-chosen productive assets (especially the more durable ones), not only can remain afloat but the better ones benefit from a rising tide that to some extent is their own making.
(By producing something useful and through reinvestment of the proceeds generated.)

A farm (especially one with some built in advantages, better yielding, well-located etc.) will still be a farm in a hundred years (assuming no development of it for other purposes) but its owner(s), and the world for that matter, will have benefited from everything it has produced over that time, plus what it's capable of producing from that point forward.

The value of what the farm produces each year will be sold at inflation-adjusted prices, of course, in whatever currency exists at that future time. So some inflation protection is built in. Also, technology has a good chance of continuing to enhance what that farm can yield per acre (better seeds, fertilizer, machinery etc.).  Compounded over a long period of time, the growth in value of this activity is far from inconsequential. This works with partial ownership via marketable securities of the right businesses (as, of course, does outright ownership).**

In contrast, an ounce of gold will also just still be an ounce of gold in a hundred years, but will have produced nothing of use or value in all those intervening years for the owner(s), and will continue to produce nothing of value. Since gold is a nonproductive asset, itsfaith-based price depends on how the changing attitudes of buyers/sellers impact demand for it, and whether lots of the yellow stuff happens to be discovered over time.

To me, that seems a pretty daunting thing to effectively judge.

I can certainly see why many would want to bet that gold, over the long run, will be worth more than all the paper money that is being printed.

It just seems that there are more weaknesses and limits to this approach than some admit.

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