Loss aversion definition
Loss aversion is when people are more sensitive to investment losses than gains of a similar value, said Prasad Ramani, a chartered financial analyst and co-founder of Syntoniq, a behavioral fintech company.
“For example, a $500 loss hurts us more than the pleasure of gaining $500,” Ramani, who’s based in Seattle, said in an email interview.
How does loss aversion affect investors?
When the market gets volatile as it did in early 2022, some investors start to get antsy, says Michelle Poston, a certified financial planner at Infinatas, based in Overland Park, Kansas.
“Is it enjoyable? No. No one likes seeing this,” Poston says. “But do we need to panic? No.”
The S&P 500 ended January down 5.3% amid concerns about inflation, the ongoing COVID-19 pandemic, and Federal Reserve interest rate increases.
The average stock market return is about 10% per year; sometimes it’s lower, sometimes much higher. But Poston advises investors not to try to time the market and not jump out on a bad day. If people are still buying stocks when the market dips, that’s a good sign.
“It will have down periods, but history has shown the market will recover and start going back up,” she says.
She says she reassures her clients that she’s keeping an eye on things. So while the fear of losing money in the stock market is understandable, knowing the market’s history may make staying invested more attractive than jumping out.
What is an example of loss aversion?
One example of loss aversion is when investors start worrying when a stock market index dips.
“People start to get concerned, especially people who are near retirement or in retirement,” Poston says.
If a retiree has started withdrawing money from an IRA, 401(k) or brokerage account, the last thing they want to see is their balance going backward, she says.
“There’s a lot of fear around losing what they’ve built and grown and not being able to afford or maintain the lifestyle they’ve become accustomed to,” Poston says.
Another example of loss aversion is when people are so fearful they avoid getting into the market at all.
Tela Holcomb, creator of Trade Your 9 to 5, teaches stock and options trading and investing and says she’s seen that firsthand.
Say a person grew up in a single-parent household and struggled to get ahead, she says. Then, perhaps they’re scared to start investing because any potential losses might mean they’ll be back to struggling financially.
“Ultimately, it boils down to that fear that you could lose this money that you worked hard for, and you’re not going to be able to make it back,” says Holcomb, who’s based in Las Vegas.
But she tells clients that investing is for the long-term, and investors should remember that.
“You are buying it for years to decades,” she says. “You don’t want to allow day-to-day news or movement to affect you.”
What can investors do to avoid making emotion-based decisions?
“Take a breath,” says Poston.
If you have a financial advisor, talk to them before you make any rash decisions, she says.
If you have a well-diversified portfolio, she says you can benefit from investing in the market. And don’t forget, if you act on your concern about loss, you’re giving up all upside potential during the recovery phase.
And loss aversion has another downside, too, Poston says.
If investors are too conservative with their investments, they could risk running out of money.
“That’s a big risk. They think they’re being safe, but in reality, they could be cutting themselves short for their financial future,” she says.
Holcomb says many times, people panic and make emotion-based decisions because they don’t have a plan.
“Have a plan for your investment before you purchase it, so when the market starts to feel crazy, you know how to react,” she says.
“Think about what kind of news or circumstance could that company find itself in that would make you take your money out,” she says. “That will help you calm your nerves because you have a plan if it were to happen.”
Ramani recommends a three A’s approach: Awareness, Analysis and Action.
He says that to avoid making emotion-based decisions, first be aware that emotions can lead to poor decisions. Second, he says, analyze how prone you are to particular decision-making biases, and third, come up with steps to de-bias yourself, so you don’t act on them without careful thought.
“To simplify, don’t act in the heat of the moment and take some time to actively seek information that goes against what you want to do,” he said.
Tips for investors
Holcomb works with a lot of people of color who are new to investing and are wary of risk. However, she says she tells all of her clients to start investing sooner rather than later to take advantage of compound interest.
And she says she knows it’s scary to be the first person in your family to invest in the stock market, but to build generational wealth, someone has to be the first.
“It is one of the easiest places to build wealth,” she says. “It’s been a space that previously hasn’t been so easily accessible to us [people of color], and the time is now.”
Ramani said investors should understand that loss aversion is just one factor that influences their decision-making.
“Also, no behavioral trait is 100% good or bad; they all tend to have both good and bad sides, which we can use to our advantage. Gaining a good understanding of one’s behavioral tendencies can help us become significantly better at investing.”