Welcome to investing psychology 101.
No matter how experienced an investor you are, the human brain is wired to have certain tendencies that influence our judgement. Although it seems that these inclinations are deep rooted in our intrinsic nature, there are things you can do to identify, suppress and control them, in order to develop a well-balanced view of your investment decisions.
Loss and risk aversion are two of the most prevalent psychological concepts in behavioural finance throughout society when it comes to financial decision-making. Early concepts of loss and risk aversion were developed on paper by psychologist Daniel Kahneman and economist Amos Tversky in the 1970s, but we can trace their presence throughout history.
What is Loss Aversion in Investing?
To define loss aversion, it is when someone has a greater negative response about a loss than positive towards a gain, even if the gain is proportionately bigger. Or in other words, the losses loom larger than the gains.
Whether it be the abandonment of the construction of the Great Wall of China in the 7th century due to financial concerns, the British retreat from Dunkirk in the 1940s to protect remaining resources and lives in the face of superior German forces, or the United States’ withdrawal from Vietnam in the 1970s after sustaining years of harm – the psychological value of loss aversion has clearly been the driving factor behind many some of the biggest global events in history.
Loss aversion also plays a massive role in financial decision-making. For example, many people are reluctant to sell a stock, even though it has lost value because they don’t want to realise their potential losses. This psychological phenomenon extends to people’s spending habits too. It is common for people to be hesitant to spend money on experiences or investments in the first place due to fear of loss.
The good news is loss aversion can be managed! One of the major ways to do this is by reframing your thinking to focus on the gain rather than the loss. Many successful people have accredited their success to a mentality that realises the opportunity cost of not selling (or buying).
Another way to manage loss aversion is to focus on your long-term goals, instead of being overly focused on the short-term. This will, in turn, reduce your fear of losing money and allow you to build confidence and believe in your decision to better your future.
The concept of loss aversion can be heavily linked to the endowment effect, which states that people tend to value things they own more highly than things they do not. Or, in other words, sentimental value. This heavily impacts people’s spending habits (e.g., thinking your car or house is worth more than it actually is), and can lead to people holding onto things longer than they should.
Put simply, a risk-averse investor tends to prefer the certainty of a known outcome over the possibility of a greater reward that comes with more risk. This can manifest in a number of ways, such as avoiding great opportunities in favour of sticking to the ‘safe’ investment strategies, or in life, missing out of some of the best experiences through fear of high risk.
Risk aversion can develop more in people who have had experiences in the past where they have perhaps taken a huge personal or financial loss and experienced such a bad feeling that their subconscious will tell them to steer clear of anything that could lead to that feeling again.
However, if this has happened to you there are a few things you can do to balance this concept and overcome these emotions. One way to balance your risk aversion is to identify and revisit the reasons that may have led to your life being dictated by risk.
Another way to overcome risk aversion is to take a step-by-step approach when making financial decisions. For example, instead of buying 100% of an investment at a single ‘risky’ point, learn to DCA (dollar cost average) your way up (e.g., 20% increments on the way up).
Gradually increasing the level of risk, allows you to become more comfortable, sort of like dipping your feet back in the water after a cold shock.
Understanding and managing the existence of loss aversion and risk aversion can be challenging, but with awareness, it is possible to make sound financial decisions that align with your long-term goals.
Whether you are aware of your bias, working to overcome it or feel as if you already have – it is always recommended that you speak with one of our financial advisors to obtain a third-party perspective and some extra guidance on what can often blindsight investors.