Why Avoiding Loss is Human – But Not Always Good for Our Wealth
Marissa Mah, B.Comm., LL.B., LL.M. - Mar 06, 2023
‘Loss aversion’, a well-documented psychological phenomenon, can cause problems for us when it works to our disadvantage in the realm of making investment decisions
Have you ever purchased something that you immediately regretted? Probably. Most of us have! Do you remember how it felt to think that you lost that money and were then worse-off from where you started? If so, it probably felt terrible!
Now imagine for a moment that you had instead been satisfied with that purchase. Do you think that the amount of happiness or contentment you would have experienced in that positive scenario would have been GREATER than the amount of pain you felt by regretting it in the original situation? Well, according to science: probably not.
This concept is known as ‘loss aversion’, and it is a well-documented psychological phenomenon. Unfortunately, like many ways that the human brain works, this concept can cause problems for us when it works to our disadvantage in the realm of making investment decisions.
Let’s take a closer look at the idea of loss aversion and explore why understanding it is important for your financial well-being.
What is ‘loss aversion’ and why do we experience it?
Loss aversion refers to the idea that losing something is more emotionally painful than the pleasure of gaining something of equal value. In other words, the fear of loss is greater than the excitement of gain.
For example, say you had $10,000 invested in the stock market. On average, a typical person would report feeling greater distress over having that investment drop in value by 20% (i.e., a loss of $2,000) than they would feel happy or content by having that same investment increase in value by 20% (i.e., a gain of $2,000). The perceived downside of losing $2,000 is considered, by most people, to be worse in magnitude than the benefits afforded by gaining $2,000.
For many of us, this inherently makes sense – after all, having nothing is certainly much worse than the advantage of having more of something you already have. The reason our mind thinks about the world this way likely has an evolutionary origin. As humans have evolved, our brains have been programmed to do things that help us avoid the worst loss that a living organism can typically experience: DEATH. In our attempt to stave off our own demise, our brains urge us not to do things that increase our chances of suffering harm. At its fundamental level, the loss of resources can be considered a harm that moves us closer to possible death – because having no food or shelter is a great way to succumb to the harsh reality of the untamed natural world. Of course, having more food and better shelter is a good way to prevent death, but having nothing essentially guarantees it. Therefore, our brain makes us feel more pain when we are threatened with losing resources, compared to the pleasure it gives us when we accumulate more.
Why understanding loss aversion is important when making investment decisions
When it comes to building our wealth, one important consequence of the human tendency towards loss aversion is that, for most people, the fear of losing money is greater than the excitement of making money. Unfortunately, this instinctual bias can sometimes lead to poor investment decisions and prevent individuals from maximizing their returns.
For example, recall the imaginary $10,000 you wanted to invest. Say you used that money to buy stock in a well-performing company that has historically increased in value over long periods of time. If the value of that stock suddenly dropped 20%, you might feel the urge to sell your remaining shares of the company to avoid further losses. However, in most situations, this would probably be a bad idea, because over the long-term, the stock will most likely recoup its losses and even become more valuable than when you purchased it. Thus, if you followed the urge to sell, you not only would have actually lost much more than if you had just waited, but you also would have missed out on long-term gains. In this way, loss aversion would harm you.
Another way this psychological phenomenon can hurt your path towards greater wealth is simply by making many of us highly risk-averse in our investing decisions. Of course, risk aversion in this context is not always a bad thing. Wanting to avoid highly volatile and speculative investments using money that you need for retirement, for example, is probably a wise strategy. However, when investing in the long-term, taking the approach of reducing your risk as much as possible can greatly hinder your financial growth. For instance, consider the difference between investing in a diversified portfolio of stocks that represent the broader market (e.g., an index like the S&P 500) compared to putting your money in a high-interest savings account. Investing in the stock market is considered to be higher-risk than keeping money in a high-interest savings account. In the stock market, the value of your investment fluctuates depending on the overall performance of the market – when the market goes up, so does your investment… but when the market goes down, your investment decreases in value. This means that you can see very rapid changes in the value of your investment, sometimes in the form of losses. Money in a high-interest savings account, on the other hand, is essentially guaranteed to only increase in value over time, as long as the bank and the account continue to exist. Therefore, from the perspective of a loss-averse brain, the security of the high-interest savings account might sound like the better option. Unfortunately, if you want to grow your wealth over the long term, this would be a devastatingly bad choice. This is because the stock market has historically produced around 7% annual returns on average over long periods of time, while high-interest savings accounts barely tend to generate much more than 1.5% interest each year (the exception being the current high-interest rate environment we find ourselves in). Consider your $10,000 investment again: if you put that money in the stock market and waited 30 years, it would grow to become approximately $76,000. In contrast, if you put it into a high-interest savings account paying 1.5% interest annually, you would only have around $15,600 after 30 years of growth. This means that if you want to build your wealth over the long-term, investing in the stock market is the obvious choice for most people – because even though there may be some short-term risks of market fluctuations, the long-term benefits of putting your money into the market vastly outweighs these concerns. This highlights another problem caused by loss aversion: it encourages our brains to focus on short-term risks without considering long-term benefits. As noted above, when our goal is to build our wealth in the long-term, this tendency clearly puts us at a disadvantage.
How to overcome loss aversion to improve our financial well-being
When it comes to loss aversion, our brain has our best intentions in mind. However, as we can see, the flaws of this evolved response can sometimes cause us more harm than good – especially when it comes to making investment decisions. Luckily, being aware of our natural tendencies is a huge first step to better ensuring we do not cause ourselves unnecessary suffering as a result of indulging our brain’s sometimes-misguided urges.
Another way to help overcome the limitations imposed by our loss-averse brain is to have someone help us remain aware of this phenomenon when we are managing our investments. One of the best approaches to this is working with an experienced investment advisor who can act as an outside voice to remind us of the ‘blind spots’ that we might encounter when making investment decisions. Indeed, an investment advisor can help take the emotion out of investing and make recommendations based on data and analysis. In doing so, they can provide guidance and support throughout the ups and downs of your investment journey, helping you to make informed decisions and avoid impulsive actions that your brain might otherwise urge you to take.
If you want to take advantage of these and other benefits of having a trusted professional protect your wealth, we would love to talk to you about how we can help you secure your financial future.