How to beat the potential harmful effects of “loss aversion” on your wealth

08 May 2024

“Loss aversion” is a type of bias that could affect how you manage your finances. It’s a concept that was developed by renowned psychologist Daniel Kahneman, who won a Nobel Prize for his influential work and sadly passed away in March 2024. To celebrate his life, read on to find out more about loss aversion and how it could impact you.

One of Kahneman’s main arguments is that people’s behaviours are rooted in decision-making. He noted that bias and heuristics – the mental shortcuts you make to solve problems – are important for making judgements quickly. However, the downside to quick decision-making is that errors can occur. One of the biases he defined was loss aversion.

Losses are more “painful” than gains

In 1979, Kahneman and his associate Amos Tversky coined the term “loss aversion” in a paper. They claimed: “The response to losses is stronger than the response to corresponding gains.”

In a study, Kahneman and Tversky asked participants if they’d rather have a:

A. 50% chance of winning 1,000 Israeli pounds and 50% chance of winning nothing

B. 100% chance of winning 450 Israeli pounds.

People were more likely to choose option B, despite the potential for larger returns if they chose A. The research found that loss aversion gets stronger as the stake or choice grows larger.

Further research highlighted that loss aversion could affect decision-making skills even when the risk of losing was very low. For example, participants were asked which option was more attractive:

A. A 33% chance of winning $1,500, a 66% chance of winning $1,400, and a 1% chance of winning $0.

B. Winning a guaranteed $920.

Even though option A only had a 1% chance of winning nothing – and the other outcomes were better than option B – loss aversion theory suggests that people are still more likely to choose option B as they think in terms of their current wealth rather than absolute payoffs.

The theory suggests that you’d feel losses more keenly than gains, which could affect how you manage your finances.

2 ways loss aversion could affect your investment decisions

There are many ways loss aversion might affect your decisions, particularly when you’re investing. Here are two examples.

1. Loss aversion may mean you’re more likely to react to investment volatility

If you want to avoid losses, you may be more likely to make knee-jerk decisions if markets experience volatility, whether it’s your investments that have fallen or the wider market. Snap judgements that are based on fear and other emotions could lead to decisions that aren’t right for you.

2. Loss aversion could mean you’re reluctant to let go of assets

In contrast to the first example, loss aversion could mean you hold on to assets even after it made sense to sell them as part of your wider investment strategy because you don’t want to make a loss. In some cases, it could mean the loss grows or that your overall portfolio is no longer aligned with your risk profile and goals.  

How to reduce the effect of loss aversion on your financial decisions

Bias affects everyone when they’re making decisions. It can be useful if you need to make decisions quickly based on your previous experiences and information. Yet, when you want to make financial decisions based on logic, there are ways to reduce the effect loss aversion might be having.

• Try to emotionally detach from your finances

It can be hard to limit the effect emotions have on your financial decisions. After all, your finances are likely to play an important role in how secure you feel and whether you’re able to reach your goals. Yet, not letting emotions rule your decisions could limit the impact of bias.

Avoiding reading the news, which might report on how markets are “soaring” or “tumbling” could help you reduce decisions that are based on emotions rather than facts. Similarly, while it might be tempting to check in on your investments every day, doing so less frequently could help you manage the emotional effects volatility can have. 

• Create speed bumps to slow down

Emotional decisions are more likely to happen in response to a particular event. For loss aversion, you might decide to sell investments after hearing in the news that a “crash” is coming, or after your investments have experienced a dip.

Often, a bit of time to think gives you a chance to reassess your initial decisions and removes some of the bias that may have been influencing you. So, creating speed bumps to slow you down might be useful. For instance, making yourself wait two days before actioning any changes to your investments may provide the space you need to think logically.

There will still be times when you decide acting on information is right for you. A speed bump might mean you feel more confident about the decision because you’ve given it extra thought.

• Look at the bigger picture

When you’re investing, it’s likely the value of your assets will fall at some point. Looking at the wider picture could help you put the losses into perspective and consider how to respond.

Let’s say a particular stock has fallen by 10% in a week. No one wants to see that when they review their investments, but how has it performed over the long term? If that stock has delivered consistent growth over several years, you may still have made a gain over the long term, and its value could bounce back.

In addition, how has the value of that stock performed in relation to other assets you hold? Gains in other areas might help to balance it out and mean that, overall, your wealth hasn’t fallen.

• Work with a financial planner

Working with a finance professional may help you better understand when bias is affecting your decisions. Having someone with a different perspective who understands your circumstances and goals may be valuable. They could highlight when you’d benefit from taking a step back and considering alternative options.

Please contact us if you’d like to arrange a meeting with a financial planner. We can discuss how we could support your goals and work with you to create a tailored financial plan.

Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.

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