Becoming a Better Investor: Deprival-Superreaction Tendency

Legendary investor and former Berkshire Hathaway Vice Chairman Charlie Munger is known for his valuable advice when it comes to money and investing. He often spoke about how human psychology plays a big role in our decision-making, both in life and in the world of investing. He identified 25 key psychological “tendencies” that influence behavior. He believed that by recognising these biases, we can avoid making rash decisions and mistakes and instead make smart, informed and investment choices.

This week, we’re looking at the fourteenth tendency, the Deprival-Superreaction Tendency, and how it has an effect on our investment decisions.

What is it?

Charlie Munger's “Deprival-Superreaction Tendency” refers to how we react to loss versus gain: in his words, loss seems to hurt much more than gain seems to help. He says, “The quantity of man’s pleasure from a ten-dollar gain does not exactly match the quantity of his displeasure from a ten-dollar loss.”

Munger described this tendency as the human tendency to react irrationally, and often disproportionately, when something is taken away from us or when we feel a potential loss. It's rooted in evolutionary psychology: losing something we possess evokes a stronger emotional response than gaining something of equal value.

To quote Munger,

“A man ordinarily reacts with irrational intensity to even a small loss, or threatened loss, of property, love, friendship, dominated territory, opportunity, status, or any other valued thing.”

This cognitive bias drives people to believe they are more capable, more lucky, and more likely to succeed than logic or data would suggest. In investment and other ventures, this bias can lead to misjudgments, like ignoring the risks involved in a particular situation, or believing investments will recover, even when the facts say otherwise.

How does it play out in the world of investing?

This cognitive bias holds substantial implications within the realm of investing. Investors may fall victim to Deprival-Superreaction bias by clinging to a stock that once surged but has since sharply declined. When a company’s value rises, investors often feel confident and validated. But when it falls, they may feel a sense of loss or betrayal over unrealised gains, making it emotionally difficult to give it up. When the value of an investment drops, we don’t just perceive it as a numerical loss, but take it personally, almost like a betrayal.

So how can we protect ourselves against this kind or irrational reaction?

• Reframe the loss: So the value of the investment we made has declined. Instead of focusing on the loss, we need to reframe the loss and ask ourselves if we would invest in the company at this time at the current price, based on the fundamentals.
• Detachment is key: Never fall in love with a stock, as Munger says. When we distance ourselves emotionally from short-term fluctuations, we are able to take a more objective approach to investments.
• Always think long-term: A long-term perspective naturally reduces the sting of short-term loss or deprival. Time tends to smooth out volatility and allows the fundamentals to shine through.

Successful investing is as much about managing our emotions and expectations as it is about managing money and studying the market. We need to recognise that our reactions to perceived losses may often be irrational. When we’re over-optimistic and emotionally tied to an investment, we might ignore the fundamentals and hold on to loss-making investments for far too long. We can solve for this bias by focusing on what matters: rational, disciplined decision-making with a long-term approach to gains.

When we acknowledge the dangers of the Deprival Superreaction Tendency, we can build guardrails around our investment process and protect ourselves from costly mistakes.