The material presented here is for educational purposes only, and is not intended to be used as financial, investment, or legal advice.
The content below has been provided by our partner, Raymond James Financial Services Advisors, Inc.
There’s No Need to Go Down With the Ship
Loss aversion makes it hard to know when to let go in order to move forward
Loss aversion. It’s what leads people to hold onto items long past their usefulness and to refuse to part with others until they get what they paid for them. It might sound wise to try avoiding losses, but taking it too far could keep you from realizing your financial goals.
The Pain of Loss Aversion
As the name implies, loss aversion is our instinct to not just prefer a gain over a loss, but to prioritize avoiding losses over almost anything. It’s the comforting appeal of sticking to the status quo and is often why those who have experienced significant financial loss due to a market crash or recession may be less likely to invest.
Our aversion to loss can be felt across many aspects of our lives – making it difficult to part with everything from threadbare sweaters to underperforming investments. In fact, research has shown that we often believe items we own are worth more than identical items we don’t – simply because we own them.1
But more than just causing you to miss out on opportunities, loss aversion can actually open you up to unnecessary risk in your financial plan. The fear of loss – which several studies have suggested is twice as powerful, psychologically, as the good feelings generated by gains – is so strong for some that they will make questionable decisions purely to avoid it.2
Loss aversion might be playing a role in some of your decisions if:
- It’s tough for you to admit when you’re wrong
- You hold on to things with emotional value
- You brood over past mistakes
- You have experienced a significant financial loss
Is Fear of Loss Holding You Back?
Money is frequently one of the things people are most afraid of losing, which means loss aversion can become even more influential – and potentially damaging – when it comes to your finances.
A 2007 study conducted by Russell Poldrack, a professor of psychology at Stanford University, monitored participants’ brain activity when presented with potential monetary gains and losses. And while he and his colleagues found that brain activity was heightened by both possibilities, it was markedly stronger when participants faced losses.
The average person is willing to risk a potential loss only if they stand to gain at least double that amount.
Source: Journal of Experimental Psychology: Vol 144(1), Feb 2015, 7-11
That fear, when applied to buying and selling investments, can hold you back when it comes to long-term financial planning. The unwillingness to part with something for less than you paid for it can keep you clinging to declining investments, whether it’s a stock or depreciating property.
It can also be hard to come to terms with the reality that a purchase may not have panned out like you’d thought. A yacht can be a worthwhile investment for some, but if you don’t have time to enjoy it, the upkeep might cost you more than it’s worth.
When loss aversion factors into your financial decisions:
- You might hold on to investments that keep losing value because you refuse to sell below a given amount.
- You may put off uncomfortable conversations around disability, long-term care and legacy planning.
- Sentiment might prompt you to hold on to possessions – or investments – that were gifted to you, even if they aren’t the best fit for lifestyle or goals.
- You might operate too fearfully and miss out on opportunities based on a past negative experience, like a market crash or a saving goal you fell short of.
- You may take on unwise risks to try to counteract an existing loss.
A study of people’s reactions to gains and losses found participants’ reactions to losing $10 were twice as strong as to gaining $10.
Source: Kahneman, Daniel (2011) Thinking, Fast and Slow, New York: Farrar, Straus and Giroux
Too strong an aversion to loss can hinder a financial plan’s progress. But it doesn’t have to be what holds yours back. While it’s natural – and often prudent – to try to avoid loss, letting that fear loom too large over your financial decisions could actually lead to the very thing you’re afraid of.
Instead, cultivating a healthy relationship with risk could be the key to gaining in the long term and helping to counteract a loss aversion bias. If you’ve been burned by the market before, it’s important to do your best to take a longer view and look past that loss. Instead of dwelling, focus on how moving forward can help you progress toward your goals.
It also helps to work with objective third parties – like our experienced wealth management team – who can offer perspective in addition to financial planning and investment support. Whatever life or the financial markets may bring, having someone you trust looking out for your best interests can help you stay on track for your long-term goals.
Think Before You Act
To help you keep loss aversion from swaying your financial decisions:
- Let’s look at your holdings with fresh eyes. If you were starting from scratch, which would you still own?
- Look at long-term market data. Experience has shown that events like the financial recession and dot-com bubble were temporary speedbumps in the consistent growth of the market.
- Give careful thought to what your true long-term risk tolerance is. We have the tools to help you stress test your portfolio and make adjustments.
1"People place a higher value on a good that they own than on an identical good that they do not own” — Kahneman, Knetsch, and Thaler (1990)
2“Some studies have suggested that losses are twice as powerful, psychologically, as gains.” Kahneman, D. & Tversky, A. (1992). “Advances in prospect theory: Cumulative representation of uncertainty.” Journal of Risk and Uncertainty. 5 (4): 297–323.
This material is not intended for use as investment advice. It does not guarantee the attainment of your goals. Individual results will vary. There is no assurance that any investment strategy will be successful. Investing involves risk and investors may incur a profit or a loss.