prefer avoiding losses

Loss aversion

The painful reality of letting go

In the previous post we spoke about risk tolerance and risk aversion. All the intricacies of our risk personality, behaviour and attitude. In this post, we are steering into a different lane – loss aversion.

It’s a common misconception to use the terms risk aversion and loss aversion interchangeably, but make no mistake; they’re distinct biases. To unravel some of the complexity of loss aversion, we engaged with Greg Davies, a seasoned Dr of Behavioural Finance from Oxford Risk.

  1. Understanding loss aversion
  2. Are we all loss averse?
  3. The investment dilemma
  4. Guarding against loss aversion

You can listen to the podcast, or watch the full episode below. If neither those options suit your fancy, then just continue reading…

UNDERSTANDING LOSS AVERSION

Where losing stings more than winning

Loss aversion, in all its complexity, manifests when individuals exhibit both risk-averse and risk-seeking behaviour, all in a desperate bid to sidestep potential losses. Why? Because the psychological weight of a loss far surpasses the thrill of a gain of equal measure.

Cognitive bias

Simply put, when you are loss averse – losing is more painful than the joy you’d feel from winning something of the same value.

Cue the crucial takeaway: when loss-averse, the pain of losing outweighs the joy of winning. Click To Tweet

Contrast this with risk aversion, where gains and losses are treated as equals – it’s the uncertainty that’s the real nemesis. However, loss aversion takes it up a notch, as it ascribes a higher subjective value to losses.

Enter Prospect Theory, which we discuss in detail in another post. This theory reveals that the subjective value we place on a loss eclipses the actual loss itself. While the degree varies from person to person, most of us grapple with some form of loss aversion.

ARE WE ALL LOSS AVERSE?

Unravelling the universal tendency

We posed the question to Greg: “Are we all loss averse?” The resounding answer: mostly yes.

The answer is mostly yes. Not everybody is loss averse in every environment. There are people who actually don’t display it in certain environments and only display it in others. But I think on the whole, it is a safe bet to say that we all have a tendency towards being loss averse. Because it is a bias, it is something that causes us to deviate from what economists think of as rational behaviour. Because it is a bias, it can cost us money. So, it is something that I think all of us need to be on guard against, yes.

While not everyone displays it universally, the tendency towards loss aversion is a safe bet. A bias that deviates from rational behaviour, it can cost us money – a call for perpetual vigilance.

We are all loss averse! Click To Tweet

Let’s now dissect when this penchant for loss aversion becomes problematic.

Examples of loss aversion in everyday life

It [loss aversion] becomes a problem when it causes our decision making to deviate from the decisions that will be best for the objectives we’re trying to pursue.

The issue arises when our decision-making deviates from the optimal choices aligning with our objectives. Loss aversion, framed in the short term, triggers decisions rooted in present emotions, not long-term logic. This discrepancy in decision-making can have a hefty price tag.

The thing about loss of aversion is because it is about framing, it is inherently short term. It’s about the decision I’m making today. And none of us ever make decisions in the long term. We only ever make decisions in the present, now. So, if I am responding to a particular framing of gains and losses in a way that makes me scared of the red, scared of the lost stuff, and it causes me to place too much emotional attention on these losses, that is correct for the decision I’m trying to make for the long term. It means I’m making a different decision to the one I should do. And that costs us money.

In investing, what is comfortable is rarely profitable.

Robert Arnott

THE INVESTMENT DILEMMA

How loss aversion impacts choices

Now, let’s zoom in on how loss aversion handcuffs our investing potential.

In the short term, a lot of people fail to invest. They fail to put their money to work because they get really scared that if I put my money into the markets today, it may go down tomorrow. And this is where loss aversion kicks in. In the long-term, tomorrow’s dip over five or ten, fifteen years is going to be utterly inconsequential to my investing activity. But right now, when I’m making this decision, it seems to matter a lot. So, what I do is I don’t invest. I postpone, I go, oh, I’ll wait till next week when I feel more comfortable. Or maybe I do invest, but instead of investing everything I need to, I only invest 50% of it. And we see all around the world, probably the biggest behavioural cost that most people make is not what they do when they invest, is that they leave too much of their savings sitting doing nothing year after year after year after year.

In the short term, many shy away from investing due to the fear that today’s market plunge might haunt them tomorrow. Loss aversion whispers in their ears, making today’s decisions feel weightier than it is in the grand scheme. Consequently, investments get delayed, scaled back, or worse, left untouched for years, a costly behavioural misstep.

I guarantee you even when times are going well, some of them will be flashing red. It draws your attention, it triggers loss aversion.

Greg also raised a valid point about portfolio checking habits. Monthly scrutiny reveals red numbers about 40% of the time, while annual check-ins drop that figure to a mere 10%. Same portfolio, same investment, but the frequency of evaluation intensifies the emotional response tied to the loss aversion.

Financial decision for potential gains

The stock market is designed to transfer money from the active to the patient.

Warren Buffet

None of us like seeing red in our portfolio. Just makes one think… if we can change our computer and mobile phone screens to dark mode, maybe there’s a gap in the market to change our trading screen from red and green to pink and purple to lighten the emotional load? Food for thought!

GUARDING AGAINST LOSS AVERSION

A strategy for success

Risk aversion and loss aversion, colossal concepts indeed, may seem daunting. However, here’s a nugget of wisdom: fortify your defences against these biases with a well-defined asset allocation plan. And think carefully about how often you assess your portfolio. Make sure it’s done in a measured timeframe so that you aren’t setting yourself up to make emotional, knee-jerk reactions.

It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.

George Soros

There’s still quite a bit more to unpack on this topic. Looking ahead, in the next post we’ll unravel the distinction between risk and uncertainty, opening the door to biases such as Gambler’s Fallacy.

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MORE IN SEASON 2 OF THE NUDGING FINANCIAL BEHAVIOUR PODCAST

In case you missed it, see our previous posts in this season
  • Risk tolerance – We chat to Steve Ward about risk tolerance; what part our personality plays and what part is influenced by external factors.

IN CASE YOU MISSED SEASON 1 OF THE NUDGING FINANCIAL BEHAVIOUR PODCAST

Here's a quick recap of all 10 episodes
  • Welcome to the podcast – An introduction to our host, Dr Gizelle Willows, and the content you can expect from Season 1.
  • Financial literacy – Don’t be financially illiterate. Allow us to take your through some quick explanations and examples on inflation and compound interest.
  • How to manage your debtLifestyle creep and easily available debt can easily lead to overconsumption and insufficient savings. Let us help you learn how to manage your debt. 
  • System 1 & System 2 -This post unpacks the workings of our brain, commonly referred to as System 1 and System 2 thinking. We chat to Dr Daniel Crosby to get some further insight.
  • The overconfident investor – We need to discuss the overconfident investor. He makes some poor investing decisions. But fear not, we’re here to help!
  • The social media echo chamber – The rise of social media and fake news is impacted by confirmation bias. It’s known as the social media echo chamber effect.
  • Narrow framing – Narrow framing, the compromise effect, glossing, and the enabling frame. We need frames to make sense of the world. But they cause problems.

  • The anchored traderAnchors tie us down and can have serious consequences for investors and traders. Don’t be the anchored trader.

  • Behavioural biases unpacked – We wrap up Season 1 of the podcast and hear about all of the behavioural biases that each of our interview guests have fallen prey to.

Are you enjoying season 2 of the podcast so far?

Do you panic when you see red?

Let us know in the comments below.

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About the Author

I am passionate about helping people understand their behaviour with money and gently nudging them to spend less and save more. I have several academic journal publications on investor behaviour, financial literacy and personal finance, and perfectly understand the biases that influence how we manage our money. This blog is where I break down those ideas and share my thinking. I’ll try to cover relevant topics that my readers bring to my attention. Please read, share, and comment. That’s how we spread knowledge and help both ourselves and others to become in control of our financial situations.

Dr Gizelle Willows


Dr Gizelle Willows

 

PhD and NRF-rating in Behavioural Finance