The pain we associate with a loss is much more intense than the reward felt from a gain. Although some investors may consider money market accounts a more secure investment option, they may not realize that they’re exposing themselves to inflation. You may know that stomach-churning feeling that comes with losing money on a stock? That pain sometimes seems to hurt more than the joy of seeing your portfolio rise. It can cause you to make irrational decisions, such as panic-selling investments that can throw off your financial plans.
Consider what happened in March 2020, when investors sold their stocks, fearing the economic fallout from the initial pandemic lockdowns. The markets bounced back within weeks and, within months, reached new highs, rewarding those who stayed calm and held on. Loss aversion can also drive you to sell your winning stocks for quick returns even when there are signs the market can climb higher, and hold on to your losers, hoping they’ll move higher again.
What is Loss Aversion?
Losing hurts. A lot. In fact, we’re wired to experience the pain of losses twice as powerfully as the joy of gains. Consequently, we’re motivated to avoid losses at almost any cost. The behavioural economics term for this engrained human trait is loss aversion. It’s why some investors retreat to the perceived safety of cash or cash equivalents when the market dips. If you’re not at least keeping up with inflation, reduced purchasing power means your goals are falling behind.
Understanding Loss Aversion
Loss aversion in where a real or potential loss is perceived as much more severe than an equivalent gain. The pain of losing is often far greater than the joy in gaining the same amount. This overwhelming fear of loss can cause investors to behave irrationally and make bad decisions, such as holding onto a stock for too long or too little time. For example, an investor whose stock begins to tumble, despite clear signs that recovery is unlikely, may be unable to bring themselves to sell due to the fear of loss in the portfolio. On the flip side, when a stock in the portfolio surges, they may quickly cash out, not wanting to see the possibility of those profits disappearing.
When an investor clings to failing stocks, departs with successful stocks too quickly and fear governs their investment decision, it’s known as the disposition effect. It’s a direct consequence of loss aversion, leading investors to make overly cautious choices that ultimately undermine their financial goals. So, understanding this bias may help investors make rational decisions to grow their portfolios while managing risk effectively. We believe investors would make better investment decisions if they understood their risk tolerance (the amount of risk they are willing to accept to achieve their investment goals) and took a disciplined approach to weigh up the opportunity cost between keeping an existing investment or not.
Conclusion
Loss aversion can prevent you from taking any risks, which can stunt your portfolio performance over the long term. All investments involve risk, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments.
