Imagine this: you’re watching a movie you’re not enjoying. However, you’ve already invested time and possibly money into the endeavour, so you feel compelled to finish it, even though you’re not having fun.
This is a classic example of “loss aversion” in action. It happens because we tend to feel the pain of a loss – in this case, the “lost” time and money – more acutely than the pleasure of an equivalent gain. Here, an equivalent gain would mean moving on to a more enjoyable activity, but it can become more complicated than that.
Loss aversion is a powerful psychological effect that can have a major influence on your investments, as it may lead you to make decisions you otherwise wouldn’t.
Let’s discuss the psychology behind this and explore how it can manifest in your investment behaviour. Then, discover some practical strategies to help you overcome this bias so you can make more informed, rational financial decisions.
Loss aversion is the tendency to feel losses more acutely than gains
Some people may be more prone to loss aversion than others, but it’s ultimately rooted in a protective, instinctual emotion – fear. Fear is an important survival mechanism that alerts us to danger. More than that, Verywell Mind states that fear can produce both physical and emotional reactions in our bodies, whether the danger is real or not.
Loss aversion is, quite literally, the fear of loss.
While the exact workings of loss aversion are still up for debate, economists Daniel Kahneman and Amos Tversky’s proposed their “prospect theory” as a way of explaining this phenomenon. First published in 1979, according to Britannica, their theory is now used in several fields to analyse how people make decisions when there is a level of risk involved.
Their research found that we evaluate potential gains and losses relative to the same reference point, rather than considering the final outcome. In fact, they claimed that we may experience the pain of a loss 2.5 times more acutely than a gain of the same amount.
For example, the pain of losing £100 feels stronger than the joy of gaining £100, even though the amounts are equal.
Though this tendency is likely rooted in human nature and instinct, it could lead you to make choices that may not be in your best financial interest.
You might avoid growth opportunities as a result of loss aversion
While being risk-averse can be helpful in some situations, a strong fear of loss could cause you to make less-than-ideal decisions with your investments. For example, you may hold onto stocks that have fallen in value, hoping for a recovery, when it may be better to cut your losses and reallocate your funds.
You might even choose to sell stocks that have risen in value too soon, as the fear of losing those profits can overpower the joy of potential future gains.
Beyond that, loss aversion can lead to excessive risk aversion, causing you to shy away from potential opportunities to grow your wealth because of the fear of potential losses.
It’s important to keep in mind that this bias isn’t simply a matter of feeling slightly disappointed. Indeed, the 2.5 times sensitivity to losses highlights the weight we place on this emotion. This can lead to irrational and even detrimental investment choices.
Fortunately, there are some techniques you can use to help mitigate these feelings and stay focused on your big picture.
3 key strategies for overcoming loss aversion
1. Focus on long-term goals
Instead of focusing on short-term market fluctuations, focus on your long-term goals. Because long-term goals are targets you set to improve your finances over an extended period, this mindset could help you maintain your sense of direction and purpose. This may help minimise the emotional effects of short-term losses, as your “big picture” plans are still in place. After all, markets have historically bounced back and continued on an upward trajectory.
Remember that investing is a long-term exercise and market fluctuations are inevitable. Focusing on your future goals can help you ride out these periods of volatility.
2. Keep calm and carry on
It’s understandable to feel anxious when the stock market falls or if your portfolio isn’t performing as well as you thought it would. However, it’s important to remember that investing is a long-term strategy. Short-term volatility is normal and reacting impulsively can harm your financial goals.
History shows that the market generally trends upwards over time, and short-term dips are usually followed by recovery period.
Take a look at the chart below as an example of how the market can recover. This covers the FTSE 100 over the last 25 years. Despite various dips, it has continued to rise.
Source: London Stock Exchange
As you can see, markets tend to rebound, even after major events like the 2008 financial crisis. The likelihood is that, following dips, there will be continued growth in the long term.
3. Speak to your financial planner
If you’re worried about the market or your portfolio’s performance, talk to your financial planner. We can be a calming influence and, by taking advantage of our expertise and guidance, you can navigate the road ahead and potentially reduce your financial stress.
We can help put your mind at ease by explaining some of the processes we put in place to protect your wealth and ensure you remain on track to achieving your long-term targets.
If you’re worried about loss aversion or simply want a fresh take on your investment strategy, we’re here to help. Email info@fourseasonsfp.com or call us on 01372 404417 to find out more.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
All information is correct at the time of writing and is subject to change in the future.
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.
