Overcoming loss aversion: strategies for savvy investors

When it comes to investing, our own behaviour often has a bigger influence on our ultimate success than the actual funds we invest in.

Traditionally, finance has been viewed through an economic lens, which assumes people make rational decisions that will benefit them. This all changed thanks to the work of Daniel Kahneman, Amos Tversky and Richard Thaler, whose groundbreaking research showed that people often make decisions that are anything but rational[1].

The fact that humans often make bad decisions will surprise nobody. However, the research uncovered that we all tend to make the same bad decisions due to behavioural biases that are largely universal.   

Understanding these biases and what we can do to counter them helps us become better investors. This is the first of a series of posts where I’ll look at the most important of the biases, explain why they exist, and share strategies you can use to stop them blowing up your financial plan.

Loss aversion

One of the most powerful biases discovered is loss aversion. This means that we feel the pain of a loss around twice as strongly as the pleasure of an equivalent gain, and prioritise minimising losses as a result.

Kahneman demonstrated this effect using a simple experiment. He told a group of students that he would flip a coin and if it landed on tails, they’d have to give him $10. He then asked them how much they’d have to win if it landed on heads for them to play the game.

In (economic) theory, any number above $10 should be enough to make it worthwhile to play, as the odds are that the student comes out on top. In reality, the answer was more than $20.

It’s thought this bias comes from our evolutionary background.

Imagine being a caveman out looking for food and hearing a rustle in the bushes. Some of our less risk averse ancestors were tempted to investigate, in the hope of finding a tasty snack. If the rustle turned out to be a lion, they were removed from the gene pool. Our more risk averse ancestors were more likely to survive, and it’s their genes that passed down through the generations to us today.

Whilst this risk aversion was beneficial for our ancestors, it’s less useful in the modern world.

Why is this important?

The loss aversion bias is particularly relevant for what we do with our money. Failing to make sound, rational financial decisions can prevent us from reaching our longer-term goals and lead to financial stress.

Some of the implications of the loss aversion bias include: 

• Not investing. Holding money in cash avoids the risk of a market fall, but sacrifices the growth potential that most people need to reach their longer term objectives.

• Being too cautious.. This typically occurs with people holding too much money in “safer” low return investments. Whilst this reduces the potential for short term losses, the big problem with a conservative portfolio is that it may sacrifice the growth potential investors need to reach their long-term goals.

• Selling when markets fall. Although this satisfies our preference to limit losses, short term falls are an inescapable part of investing. Selling out at the first sign of trouble backfires by both selling at a loss and missing out on gains when markets rise again.

• Holding on for too long. Conversely, for some people keeping a bad investment can mean they don’t have to psychologically realise the loss. This can prevent the money being invested in an investment with better growth potential.  

Tips to counter loss aversion

Loss aversion is emotionally hardwired into all of us. We’re likely to fall prey to it if we’re making decisions in an emotionally charged state (such as when we’ve seen our portfolio fall in value), so the key is to prepare in advance.

1. Set clear investment goals

One of the most effective ways to counter loss aversion is to establish clear, long-term financial goals as part of a financial plan.

Defining what you are working towards—whether it's retirement, a new home, or education for your children— can help shift your focus from short-term market fluctuations to the bigger picture.

A financial plan will map out what needs to be done in advance so decisions don’t need to be taken at a time when emotions may be running higher, and the effects of our biases are stronger.

2. Educate yourself about market cycles

Understanding market cycles can provide context for why losses occur and how to respond. Historically, markets have experienced fluctuations, but they have also shown resilience over the long term.

An investor who understands this cyclical nature is less likely to panic during downturns, thus resisting the urge to prematurely sell investments simply because of short-term losses. Regularly discussing historical trends with your financial adviser can reinforce this knowledge and confidence.

3. Diversify portfolio

A well-diversified portfolio is a practical hedge against loss aversion. By spreading investments across various investments, you reduce the impact of any single asset performing poorly. This strategy not only mitigates risk but can also provide a more stable return profile, making it easier to manage emotions in the face of market downturns.

A favourite quote of mine comes from Nick Murray who said,

“A permanent loss in a well-diversified equity portfolio is a human achievement of which the market itself remains incapable.”

Whilst it’s absolutely possible to lose money if investing in a single stock or concentrated portfolio, historically it’s been almost impossible to lose money in a well-diversified portfolio – provided we don’t sell during a market downturn.

4.  Limit your exposure to ‘financial news’

For those with an especially strong loss aversion bias, it may be wise to go on a media diet. Financial media is filled with doomsayers predicting the next meltdown, and even reputable sources focus on the dramatic short-term ups and downs in the market, rather than on longer-term performance trends.

Avoiding financial news can help insulate people from experiencing the fear that may lead them to make harmful short-term decisions.

5. Focus on long-term performance

Remember that investing is a long-term game. Instead of fixating on day-to-day fluctuations, concentrate on your portfolio's overall performance over time. This shift in perspective can reduce the emotional weight attached to short-term losses.

Regularly revisiting your investment strategy based on long-term metrics, rather than reacting to immediate losses, will help reinforce a forward-thinking approach.

Summary

Loss aversion affects us all and is a challenge that every investor faces.

Understanding this psychological barrier and implementing practical strategies can help you navigate market volatility with confidence.

A financial adviser can help guide you through these emotional hurdles, helping you stay focused on your long-term goals and making informed investment decisions.

With discipline, education, and a strong investment strategy, investors can rise above the fear of loss and make sensible investment decisions to reach your life’s longer-term objectives.

The value of an investment in equities and shares may go up and down. You may get back less than the amount invested. This is different to the capital security typically associated with bank deposits held in cash.

[1] What is behavioral economics, University of Chicago, accessed 30th September 2024 https://news.uchicago.edu/explainer/what-is-behavioral-economics