Is the Fear of Investing Rational or Irrational?

As a finance professional, I speak to many people about money, in a personal context as well as corporate. One clear-cut finding I have drawn from these conversations is that the majority of individuals are afraid to invest directly in the stock market.

My next question is usually as follows: “Why do you have a fear of investing in the stock market?”, to which they tend to reply with: “Because I want my money in a safe place, people lose money in the stock market all the time, and I don’t understand it at all.”

I was struck by the sad reality of this situation. Finance professionals (be they actuaries, financial advisers, and so on) agree that stocks, or ‘equities’ are the asset class with the highest expected return over long periods. They say this because it has been true in the past, which is reasonable as they look over a horizon of over 100 years in span.

Interest rates in 2012 are at record lows in Western Europe and the USA. In such a scenario, those who fear the stock markets are not even earning enough interest to keep up with inflation, meaning that the spending power of their money is actually reducing over time. This is also known as a ‘negative real return’.

And so the sad reality becomes very apparent. Every day, across the country, families are refusing to invest for their future in the highest expected return asset class, and are instead investing in a savings account which will reduce their wealth the longer they try to save.

This raises the key question – is this fear Rational or Irrational?

The case for rationality is strong. Ordinary workers may be prepared to take risks in other elements of their lives, but financial risks seem to receive a very strong emotional response. Psychologists have proved over and over that humans perceive gains differently to how they perceive losses, (They dislike losses disproportionately more than they like gains), this has been coined ‘loss aversion’.

In this respect – staying away from the stock market is a rational choice. This decision will ensure the investor will minimise the potential for emotionally destructive losses to occur.

The case for irrationality also has merit. If the savings in low interest bank accounts are earning a negative real return – then to choose a bank account is to accept a guaranteed loss in purchasing power. Loss aversion tends to lead people to make decisions which give them a possibility of no loss. And in this scenario – only equities are likely to provide that option.

This is therefore a difficult dilemma. In order to avoid large losses, investors are accepting smaller ones, but in doing so – are denying themselves the asset class which has the best chance of giving them an optimal retirement fund.

I suppose that it is just as well that employer pension funds (such as 401ks) are automatically investing heavily in equities without investors really paying attention. This way, the pain of losses is not felt, and the highest returns can be expected.

Simon Oates writes about how to invest in shares on his blog Financial Expert.