Does Loss Aversion Affect My Finances? Nobel Laureate says YES

You must be wondering why I write so much on Behaviour Finance aka Investor Psychology. I firmly believe “Investing is not a Number Game it’s MIND GAME”. You will be happy to know that this year’s Nobel Prize in Economics Sciences went to Richard Thaler (Author of Misbehaving book) for his contribution to Behavioural Economics. Loss Aversion post is based on a concept introduced by Daniel Kahneman in his famous book Thinking Fast & Slow – he is also a Nobel Laureate.

Check what Loss Aversion is, how it affects your investments & what you can do?

Loss Aversion

It is a human tendency to avoid a loss as much as possible. A loss of Rs. 1000 gives us much more pain than the amount of joy we derive when we gain Rs.1000. Humans have a bias against loss and this has been proved in many behavioral studies. Loss aversion must be inbuilt in humans as in ancient times, being careless in hunting or an injury or getting excluded from the group could lead a human to die as the world was harsh. Therefore people who were cautious survived and we are their descendants. So evolution has made us such that we fear loss more than we like gain.

This post was tweeted by Paul Resnik – he is one of the best guys in Financial Planning industry who understand Investor Behaviour & Risk Profile.

Loss Aversion Examples

Few day-to-day examples – we are hesitant to sell a favorite old car or a piano even if it is not of much use to us now. If we are forced to sell it, we ask for a high price as we feel we are giving away something valuable and cannot bear to see it go.

Don’t we all get tempted by offers such as ‘Buy 2, Get 1 Free’ even though we might not need three! We want to take up the offer as we do not want to lose the one that is given free.

We are apprehensive of taking up a new role in the company we work in or change a job as we are in a comfortable place and do not want to risk it. Caution is good but being so cautious that we do not take up any risks or challenges will not help us achieve our goals or ambitions.

Read – Impact of Hindsight Bias on Your investments

How does Loss Aversion affect out personal finance?

1. Many of us do not sell loss-making investments hoping against hope that someday they might be profitable. This delay leads to further loss due to the erosion of the capital value.
2. On the other hand, we tend to sell off stocks whose prices are rising. We feel that if we do not sell them, prices might fall and we will end up making losses.
3. Many investors stay away from falling markets as they cannot digest losses. But when the markets come back to the true valuations, high-quality stocks & Mutual Funds would bounce back. People would have lost the chance to buy attractive stocks at low prices.
4. We invest maximum amount in safe, low-interest investment products that provide no great returns nor are able to beat inflation.

Check – Throwing Good Money after Bad

This behavior of averting losses leads to reduced gains.

How we can avoid losses due to this kind of behavior –

1) Do not check your portfolio on a daily basis –

It is not necessary to check your investment portfolio on a daily basis as it is supposed to be based on a long-term view. If you check it daily, you may get disappointed when your portfolio shows a loss or a lesser profit than the previous time you checked. This may lead to actions based on panic and emotion which may not be in the best interests of your financial health. It is better to check the portfolio less frequently as you will see very few instances of losses.

Check – Effect of Holding Period on Returns and Risk

2) Think logically –

When you want to invest in a product or sell off a product or change your job or buy something of significant value, think of these points –

• Why should you do it?
• Why should you not do it?
• What are the risks involved?

List out the pros and cons. This will help you in reaching a rational decision.

Read – The Art of Thinking Clearly 

3) Turn around loss aversion as an advantage –

Loss aversion is good up to an extent. It prevents you from making mistakes. It helps in making you think about various aspects of a decision. You can use it to your advantage. When you decide not to buy an investment product and its price goes down over a period of time, remember it and congratulate yourself for the right decision. When the markets are volatile, and you do not react but wait for them to stabilize, remember to pat yourself on the back. Mark out the days when you took a positive action. You will feel motivated to mark out all days as a day with no marks will disappoint you and push you to do something positive. It can be anything – going for the morning walk, learning to swim or taking a step towards building your financial portfolio.

Our investment behavior is influenced by many behavioral aspects and loss aversion is one of them. We should work towards managing it so that we do not err in decisions related to our financial health. What you can learn from well-Behaved Investor

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