Reducing our Loss Aversion

30th Apr by Joe Byrne

Reducing our Loss Aversion

In psychology (the science of mind and behaviour) and decision theory, loss aversion refers to people’s tendency to prefer avoiding losses rather than acquiring equivalent gains. Some studies have suggested that loss aversion is twice as powerful, psychologically, as gains.

As an example, we have all heard about the downfall of Lance Armstrong. If you’ve followed his career at all, you know how committed this guy was to winning. In the documentary “The Armstrong Lie” it opens with a close-up shot of Armstrong’s chiselled face staring intently into the camera and explaining what drives him:

“I like to win, but more than anything, I can’t stand this idea of losing. Because to me, losing means death.”

It played out that way. Armstrong decided that avoiding the pain of losing was worth any cost. Now, it seems as if it could very well cost him everything.

Turns out that most of us don’t like losing. In fact, it’s what the academics call loss aversion. We feel the pain of loss more acutely than we feel the pleasure of gain. In other words, we may like to win, but we hate to lose.

The psychologists Daniel Kahneman and Amos Tversky[1] showed that even something as simple as a coin toss demonstrates our aversion to loss. In a recent interview, Mr. Kahneman shared the usual response he gets to his offer of a coin toss:

“In my classes, I say: ‘I’m going to toss a coin, and if it’s tails, you lose $10. How much would you have to gain on winning in order for this gamble to be acceptable to you?’

In my classes, I say: ‘I’m going to toss a coin, and if it’s tails, you lose $10. How much would you have to gain on winning in order for this gamble to be acceptable to you?

“People want more than $20 before it is acceptable. And now I’ve been doing the same thing with executives or very rich people, asking about tossing a coin and losing $10,000 if it’s tails. And they want $20,000 before they’ll take the gamble.”

In other words, we’re willing to leave a lot of money on the table to avoid the possibility of losing.

We see this aversion to loss play out in the lives of real people when we try to make smart money decisions, especially when it is time to make a change to our investments. It almost does not matter what change we need to make. We hesitate to change from the current situation because it means having an opinion and ‘making a decision’. With a decision comes the very real possibility that we will make the wrong one. Sticking with the status quo feels much better, even if we know it is costing us money.

Just think of the things you will not do, even though you know you should. For example, let us imagine that a few years ago, you invested in the process of planning and built a financial plan based on your values and goals. Now you have a portfolio of low-cost, diversified investments, but you are still holding on to a stock your brother-in-law recommended years before that went down right after you bought it. It clearly does not fit in your plan. Every rational thought, every spreadsheet and every calculator tells you that it is past time to get rid of it, but you don’t.

Making the choice to sell, would mean realising a loss. To some degree, it means admitting we have made a mistake, but we would feel the loss too. As we have discussed, we are wired to go to great lengths to avoid that feeling. Once we realise that loss and open ourselves up to the pain of that experience, we will discover that we feel almost twice the emotion over a loss as opposed to a gain.

To get past our aversion to loss, try taking the ‘Overnight Test’. It is an excellent tool that helps us separate the emotion from a decision. Let us go back to the earlier example. You have a low-cost, diversified portfolio, and you have the stock your brother-in-law recommended. Now, let’s play a little game.

Imagine you went to bed, and overnight someone sold the stock and replaced it with cash. The next morning, you have a choice: You can buy back the brother-in-law’s recommended stock for the same price, or you can take that cash and add it to your well-designed portfolio. What would you do?

Most people would not buy the stock back.

Just by changing your perspective (investing cash versus getting rid of the stock), you can gain clarity and have the emotional space to make the decision you know you need to make. Sometimes, that’s all it takes. While we will probably never embrace loss, it is good to know that we can find ways to work around our aversion, when it makes sense.

The source of this article was Carl Richards (Behavorgap.com), accessed through our investment consultant Consilium NZ Limited. If you have any questions and would like to discuss this further, please speak to your financial adviser.

 

Article by Joe Byrne, BA, AFA - Read More

[1] Daniel Kahneman and Amos Tversky, Prospect Theory: An Analysis of Decision under Risk, Econometrica, 47(2), pp. 263-291, March 1979

Disclaimer– This document has been prepared for the purpose of providing general information, without taking into consideration any particular investor’s objectives, financial situation or needs. Any opinions contained in it are held as at the report date and are subject to change without notice. This document is solely for the use of the party to whom it is provided.

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