Loss Aversion Is Making You Throw Away Money

Imagine there was something primordial inside of you making you toss away the most coveted item on earth, money. This force can keep you from recognizing things that make you the most money and make you focus instead on anything that costs you anything. It isn’t making you do this directly, but it is causing you to ignore the opportunity cost that helps your money grow over time. Loss aversion and investing is a dangerous combination.

Have you ever wondered why people barely react to getting $1,000, but will completely lose it when they lose $1000? Loss aversion is what we’ll talk about here today and it’s a nasty little tick that we all have when it comes to managing our money and how we react when we lose it or gain it.

It’s such a powerful force that investment advisory firms such as Franklin Templeton and Hartford Funds have articles to help their advisors understand how it can impact investing decisions and how to help their clients avoid making costly mistakes.

The Loss Aversion Concept

If I gave you a $1 would that feel to you as good as how bad you would feel if I took away a $1? Probably not. On average, people feel the negative loss of a $1 twice as much as they do the gain of a single $1.

Think about this for a second.

How many times have you not asked for a raise in a 5-minute conversation with your boss but tried to save an extra $5 a month by downsizing one of your subscription services or cutting out some other expense? Or tried to save money cutting coupons when you could walk your neighbor’s dog and make 2x what you just saved couponing? Or have you decided not to quit to go to a better job because of losing out on a small amount of bonus from your last company?

Loss aversion keeps you from seeing the upside from monetary transactions because losing money sucks for humans. Even just a little bit feels like 2x the loss as compared to a dollar gained.

We can see this relationship from the chart below. What we also notice is that curve in the “loss” quadrant is far more severe than the curve in the “gain” quadrant. This means that the relationship holds even for seriously huge gains in money.

You need to make a lot more money to feel relatively better than even a small amount of loss.

Source: Wikipedia

Imagine you’re selling your house and you believe you’re going to have a loss as a result of the sale. It’s likely that you’re going to act pretty irrationally. Research has actually shown that sellers will overprice their homes when they believe they’re going to take a loss selling the home.

Loss aversion can come into play when investing in stocks as well. Imaging you’ve purchased one specific stock that has drastically under-preformed for a significant period of time and its prospects to recover are not strong. You may, for whatever reason still want to hold on to that stock, and many investors do, but it can be a costly mistake. This feeling has little to do with being a shrewd investor and more likely is due to loss aversion. You simply don’t want to walk away realizing a loss in your portfolio.

See why this could be a problem? Your poorly invested money in one holding could be dragging down your ability for that money to thrive in another investment somewhere else.

On the opposite side of this trend is the race for investors to sell at even the slightest signs of trouble and move into all cash positions in their portfolio to avoid further losses. This is really important. Behavioral science is telling us that if we try to sell into a downturn to time the market and buy back in the losses can be roughly 15% of our annualized returns.

Risk Aversion v. Loss Aversion

Risk aversion and loss aversion are not the same things. That’s one thing you need to walk away from this article understanding. Risk aversion, unlike loss aversion, related to someone not wanting to take on riskier investments with their money. Loss aversion relates to someone not wanting to take a loss.

For instance, my mother has held her portfolio in the least risky possible assets available in her 401k for some time as she’s neared retirement. The returns are low, but the returns are virtually guaranteed. She has a very low risk tolerance at this point in her investing journey.

Loss aversion, on the other hand, would be more akin to her putting all her bets on one stock that tanks 80% overnight due to some external issue, let’s say the loss of a critical lawsuit that will push them into bankruptcy. It’s probably time to take that other 20% out of the investment and put it somewhere else. If it’s put into another investment it could certainly turn around, but selling the investment when it’s dropped 80% would mean the realization of a 80% loss which will hurt your overall portfolio. If you have serious loss aversion, this is likely something you’ll not even consider.

Summary

Most people who are telling you not to sell when the market starts tanking are usually telling you to avoid the consequences of loss aversion. Sure it feels good to get your money out of a falling market, but you need to know that it can seem 2x worse to suffer a loss than the upside you may feel during a market increase. If the market changes the next day after a sell-off and you’ve move your portfolio to the sidelines, you’ll likely look back with some regret even though you appeased your short term fears of losing more money.

Loss aversion and investing go hand in hand. It can cloud even the smallest decisions in life and it can severely cloud your decisions about the biggest investments you’ll ever make including home-buying and investing in the stock market.

If you walk away from this article with one thing stuck in your head let it be this:

You need to make a lot more money to feel relatively better than even a small amount of loss.

References

For more academic studies on loss aversion, check out the below publications:

Haigh, Michael S. and List, John A. (2005). “Do Professional Traders Exhibit Myopic Loss Aversion? An Experimental Analysis,” The Journal of Finance 60 (1), 523-534.

Kahneman, Daniel, and Amos Tversky. (1979). “Prospect Theory: An Analysis of Decision under Risk.” Econometrica 47 (2), 263292.