What is Loss Aversion?
By nature, as human beings with emotions, we exhibit a tendency known in economics as loss aversion bias. The pain we associate with a loss is often more significant than the happiness equated with a gain of equal magnitude. If you’ve ever gambled, you know the feeling. it’s nice to win, but even the smallest loss can make you question placing a wager in the first place. Similarly, even knowing that odds are against us, we sometimes like to bet on long-shots vs. favorites, seeking a significant upside (happiness) to offset even losing a small amount of money (pain).
Loss Aversion & Investing.
Thankfully, prudent investing is not like gambling. When you make a bet and lose, that money is lost. Your only hope now is to double down, take more risks, and hope you are smart enough to walk away if you break even.
With investing, actual losses are only realized when assets are sold, and lower prices are “locked in.” More commonly, paper losses recover as markets rebound, and long-term trends drive returns. Over time the odds are in your favor as an investor, and as you likely know, they are not as a gambler.
That distinction aside, our loss aversion bias has kicked in pretty aggressively as of late, with markets and portfolios down on the year. Emotions have come to the forefront, and long-term views are thrown away. Our bias is further compounded by the constant noise of ever-present news feeds, opinions, and hot takes. But when we take a step back, we can see that the current price levels are causing us all this angst were ones that we were enthusiastic about just over a year ago.
Source: Yahoo Finance
Why It Matters.
Loss aversion bias can cause more than negative feelings and, in some instances, will lead to poor investment decision-making. We may prioritize avoiding the pain of investment losses at the sacrifice of gains (also known as risk aversion). This includes overly conservative portfolios, de-risking at inopportune times and full-fledged market timing. (See our white paper here: Market Timing: Investing or Gambling? | Strategic Financial Services (investstrategic.com)). This can result in portfolios underperforming desired growth or the growth necessary to achieve specific goals.
To avoid the pitfalls of loss aversion bias, the first place to start is refreshing ourselves on the long-term trend of the stock market. Again this is not gambling and “losses” don’t evaporate instantly. The stock market has always recovered and achieved positive long-term returns. Investors should establish the proper level of portfolio risk based on our ability and need to take risk in combination with our willingness and desire to do so. We can also prepare for these moments before they arrive by reviewing scenarios and continuing to confirm risk profiles over time. This allows the rational side of our brain to have a fighting chance during emotional times.
For earlier investors and accumulators, these moments create opportunities to buy at lower prices, and many will do so systematically in company 401(k) plans, children’s college funds or brokerage accounts. For other investors, proper rebalancing will naturally shift diversified portfolios towards risk assets where valuations are more attractive.
Investing can be emotional, but those emotions can be our own worst enemy. It is important to acknowledge these tendencies, take a step back and keep an eye on long-term goals.
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