Why loss aversion could be hurting your investing returns

April 10, 2022

While we all like to think we can make objective and rational decisions, it can be easy for your emotions to take over during periods of uncertainty. When there are sharp falls in the market, it’s easy to be influenced by panic when you think about your portfolio.

Of course, when you make investing decisions based on how you feel, rather than on the facts, you may be more likely to make mistakes.

One big psychological bias that can come into play during uncertain periods is “loss aversion”, which is the tendency to fear losses more than valuing gains. As you might imagine, this can lead you to make poor decisions with your investments and potentially damage your long-term prospects.

Read on to find out everything you need to know about loss aversion.

Loss aversion is a psychological bias that prioritises avoiding losses over making gains

To put it simply, the theory of loss aversion is that people feel the pain of losing much more strongly than the pleasure of gaining.

First identified in the 1990s by psychologist Amos Tversky and economist Daniel Kahneman, the key premise of this idea is that people react differently to positive and negative change. Their studies found that participants felt losses twice as strongly as gains, which could skew their ability to make decisions.

This might seem strange but considering how you might react in that situation can make it easier to understand.

For example, let’s say you were offered a guaranteed payment of $900 or a 90% chance of winning $1,000.

While the latter could lead to higher returns, there is still a 10% chance that you could win nothing at all. Even though the risk is small, it can be tempting to avoid it altogether by taking the former option, even though you have a good chance of gaining the larger amount.

Conversely, imagine that you had the choice between a guaranteed loss of $900 or a 90% chance of losing $1,000.

Here, you may prefer to take the latter option, as even though you could lose more money, there’s still a 10% chance of losing nothing at all. As you can see, it can sometimes be tempting to opt for a riskier decision in the hope of avoiding making a loss.

This psychological bias could hamper your investing strategy

With the fact that you may feel losses more strongly than you would gains, it’s no surprise that this psychological bias can affect your decision-making when investing.

When making important financial choices, it can be tempting to focus more on the risks that an investment poses, rather than the potential profits you could make. This feeling can be especially strong during times of uncertainty, when you might have underlying anxieties.

In recent months, the global economy has experienced a significant amount of volatility. Not only are many countries still recovering from the strain of the coronavirus pandemic, but the recent war in Ukraine has also heightened the anxieties of many investors.

If this recent volatility has worried you, it could affect your investing in three main ways:

Holding too much wealth in cash

When markets are volatile, it can be tempting to hold a large portion of your wealth in cash. As we discuss elsewhere, while this may reduce your risk of making a loss, doing so would expose more of your wealth to the corrosive effects of inflation. This could reduce its buying power over time.

Refusing to sell shares that are making a loss

Sometimes, investments don’t work out and the best thing to do is cut your losses and move on. However, this psychological bias can persuade you to hang onto struggling stocks, in the hope that they might recover. This can turn a small loss into a much larger one.

Lowering your risk tolerance

Another important way that this psychological bias can affect you is by making you lower your tolerance to risk. This can lead you to avoid investments which could offer greater returns, out of fear that they may fall in value.

Working with a planner can help you to invest more effectively

If you want to reach your long-term goals, it’s important to be able to make rational and objective decisions about your finances, as biases like loss aversion can affect your progress.

This is where seeking professional advice can really benefit you. When you work with a financial planner, they can act as a sounding board when investing, helping you to avoid knee-jerk reactions that could damage your long-term prospects.

They can also provide guidance and make useful suggestions throughout your investment journey to ensure that your portfolio is sufficiently diversified and protected from shocks.

Above all, working with a planner enables you to invest with confidence, knowing that you’re making the right decision and are on track to reach your goals.

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