Although that might sound a little counterintuitive, even odd, it’s a dilemma that is especially relevant to investing, where we often have to weigh up the risk against potential reward.
A high-risk investment could potentially earn you a higher return than a lower-risk investment. But the potential for losses is also higher. So, as investors, we weigh up the potential gains and losses and make a decision based on the likely outcomes.
However, our human predisposition to loss aversion suggests that we are not necessarily that rational when making investment decisions as losses tend to “hurt” more than gains “please” us, some behavioural economists have said by twice as much1.
Imagine you are offered either a guaranteed £1,000 or a 50:50 chance of either winning £2,000 or nothing at all based on the simple toss of a coin. Most people would opt for the guarantee of the £1,000. After all, the proverbial bird in the hand is worth two in the bush.
Double or quits?
Now imagine you are facing a certain loss of £1,000, but this time the coin toss has a 50:50 chance of either doubling or eliminating it completely. Which option would you choose? Most would take the risk of doubling up, even though there is no rational reason for taking the bet when faced with a loss compared with a gain.
Now let’s consider another scenario. You took a bet on an individual share that didn’t pan out as you had hoped. The position is showing a large loss and has been sitting there for a long time. What do you do? You know there’s probably a better way to invest the money but still you hold on. That’s because it doesn’t feel like a loss until you’ve actually sold it. Loss aversion may keep you from moving on and acting in your own best interest.
How else can loss aversion come into play? The fact we fear losses more than we value gains could lead us to take less investment risk than we could tolerate or would be suitable.
It is this fear of losses that prevents many potential investors from taking the first steps into investing, preferring the perceived safety of a bank account or leaving cash uninvested in their individual savings accounts (ISAs) or pensions, even though it’s likely to lose money due to inflation.
It can also lead to more experienced investors taking on too little risk. Over a lifetime of investing, this irrational conservatism could cost you thousands of pounds.
How to use loss aversion to your advantage
Don’t like losing money? Remind yourself that not investing also comes with a loss, especially during times of high inflation, which reduces the purchasing power of your money. Over multi-decade time horizons, this loss can grow to be very significant.
The next time you are making an investment decision, take a step back and remind yourself that although you may lose money, long-term investors with a broadly diversified portfolio have tended to be rewarded for the risk they have taken.
1 Tversky, A., & Kahneman, D. (1971). Belief in the law of small numbers. Psychological Bulletin, 76(2)
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