When markets are uncertain, it’s easy to let emotion take charge and control your decision-making. Even if you’re a logical person, it’s completely human to be influenced by a fear of losing money.
This is “loss aversion”, a psychological bias that can lead you to make emotion-led investment decisions, take less risk than you can tolerate, and even go as far as damaging your potential returns.
Thankfully, there are steps you can take to mitigate the effects of this cognitive bias, so continue reading to find out exactly what loss aversion is, and how you can avoid falling into its trap.
Loss aversion is a psychological bias that makes you subconsciously avoid “losing”
Loss aversion is essentially the theory that “losing” is psychologically more dominant than the satisfaction of “winning”.
The philosophy was initially identified by the psychologist, Amos Tversky, and economist, Daniel Kahneman, in 1992, and it shows that people tend to react differently to positive and negative changes in wealth. Indeed, people feel the pain of losses twice as strongly as the pleasure of gains.
This is much like a gambler who is on a losing streak but keeps betting as they want to avoid a net loss, or someone who gets a gym membership and keeps making payments long after they stop visiting.
To show how you may be affected by loss aversion, imagine you were offered either a guaranteed payment of £900 or a 90% chance of winning £1,000 (and a 10% chance of winning nothing).
Even though the second option has the chance for higher returns, it’s easy to avoid it altogether as there is risk involved, even if this risk is only small.
Meanwhile, let’s say you were then given the choice between a guaranteed loss of £900, or a 90% chance of losing £1,000. You may find that you’d be more likely to take the second option in this instance, as there’s still a 10% chance you lose nothing.
This is essentially loss aversion – you’re building your investment decisions around avoiding risk, even if that is the less optimal choice. Continue reading to find out how this mindset could end up costing you.
You could end up leaving money uninvested or hold on to a poor investment with loss aversion
When you’re investing, loss aversion can make it easy to focus on the risks that come with an investment, rather than the potential profits you could earn from it.
This is especially the case during times of market uncertainty, much like we’re seeing today with Russia’s war in Ukraine and a looming recession.
One mistake you could make is holding too much cash in a savings account with an uncompetitive interest rate to avoid “losing money” during a period of market uncertainty. While you may feel your wealth is safe, with inflation currently so high, it’s likely your purchasing power is being eroded in real terms.
Also, you may refuse to sell shares that are losing money as you feel that if you hold on to them instead of selling, they might eventually recover, and you could avoid losing money on your investment.
While this is an understandable human reaction to a bad investment, you could end up turning a small loss into a big one by not selling your stake.
Loss aversion can also lower your risk tolerance too much. While it is important to be wary of risk when you invest, being too risk-averse could result in you avoiding riskier investments with higher potential for returns from fear that they could lose you money. This might mean you don’t generate the returns you need to achieve your long-term goals.
There are steps you can take to mitigate the effects of loss aversion
You may now realise that when you let loss aversion influence your investing decisions, it can jeopardise your chances of meeting your long-term goals. Thankfully, there are steps you can take to mitigate its effects on your decision-making process.
Construct a balanced portfolio
You should closely examine and identify your tolerance for risk before you even start investing. When you do so, you can then tailor-make a well-diversified portfolio that spreads risk across several different types of asset classes in different sectors, industries, and markets.
For example, if you invested all your money in tech stocks, and the tech sector subsequently experienced a period of downturn, you would be more likely to lose money than if your investments were spread across several different sectors.
Ensuring your portfolio is well-balanced can reduce the risks of your investments all losing their value at once, thus limiting loss aversion.
We can help you to create a well-diversified portfolio, aligned with your tolerance for risk.
Make changes to your portfolio less frequently
Loss aversion can often make you feel as though you should alter your investment strategy when short-term swings in value occur. Though, historical market data shows that you’re less likely to lose money when investing over the long term.
Indeed, data from Nutmeg shows that if you randomly picked one day to invest, and held this investment for only 24 hours, you would have a 52.4% chance of positive returns. Meanwhile, if you held the same investment for 10 years instead, your chances of positive returns would climb to 94.2%.
Similarly, the above source shows that long-term investing reduces your odds of loss altogether. If you hold an investment for one year, you would have roughly a 25% probability of loss, though hold this same investment for 10 years and your odds of a loss drop significantly to 5%.
As you can see, your emotional reaction to short-term market dips could end up costing you, since long-term investing has a greater chance of positive returns. So, you should try and avoid making rash decisions when values dip.
Work with a financial planner
When your money and livelihood is on the line, it’s often difficult to separate knee-jerk emotional reactions from rational thoughts. As such, working with a financial planner is a great way to mitigate loss aversion.
When you work with a planner, you’ll have an expert to talk through your investment strategy with you. They can act as a sounding board to help you avoid emotionally led decisions.
A planner can also ensure that your portfolio is suitably diversified and thoroughly monitor the performance of your investments and then refine your investment strategy accordingly.
Get in touch
When markets are uncertain as they are now, it’s easy to let emotion take charge of your decision-making. To discuss ways you can avoid letting loss aversion influence you, please call 01992 500261 or fill in our online contact form to organise a meeting and we’ll be in touch.
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.