This is part three in my series on biases, or unconscious prejudices, which commonly have a negative impact on investors.
It may look like a numbers game, but investing is really all about people. It is crucial to identify your unique traits and desires, and tailor your financial goals accordingly. It is also crucial to understand how you will reach those goals, and how you might get in the way of achieving them. In my 8 article series, I will walk you through eight biases that often interfere with a sound investment strategy. Certain psychological tendencies can sabotage our best efforts to grow wealth, so acknowledging and taking steps to mitigate them is key to long-term success. We help all our clients develop financial goals and remove the obstacles to those goals.
People tend to feel loss more strongly than gains; the emotional impact of losing a certain amount of money is generally more than the impact of winning the same amount. To demonstrate this, researchers asked participants if they would accept a bet based on flipping a coin. If the coin came up tails, the participant would lose money, and if it came up heads, the participant would win money. The researchers found that, on average, people needed the opportunity to gain twice as much as they stood to lose in order to take the bet.[1] The tendency to avoid losses is called Loss Aversion Bias. It is also known as Regret Aversion Bias because some hypothesize that the feeling of regret experienced after making a choice with a negative outcome causes us to give loss greater weight.
Our desire to avoid loss or the regret associated with making a choice that results can affect our investment decisions. Not only does it decrease risk tolerance, it causes people to forgo long-term investment strategies that would likely be very profitable because those strategies might not have short-term rewards. This myopic view causes people to pull out of the market when there is a downturn instead of riding it out and reaping the benefits years down the road.
The first step in tackling loss aversion bias is to acknowledge it. Understand that you will lose money on some investments and be willing to stick with them when long-term gains will outweigh short-term losses. Having an objective perspective on which investments are long-term winners and which ones are likely to keep up the short-term losses is critical. With a view towards the long-haul and the help of neutral advisors, risk aversion bias can be countered.
[1] Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47, 263-291.