Fact – we all hate losing money. But did you know that investors can often dislike losing money more than they should? 

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. Some behavioural economists have said that losses tend to hurt twice as much as gains please us¹ . 

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. It can also lead to more experienced investors taking on too little risk. 

Over time, this could prove costly and make it harder to achieve your financial goals. Although share prices can fall as well as rise and you may get back less than you invest, shares have historically delivered far superior returns than cash over the long term.

How to use loss aversion to your advantage

Don’t like losing money? 

The next time you are making an investment decision, take a step back. Remind yourself that although you may lose money, long-term investors with a balanced portfolio that spreads money across different assets, such as shares and bonds² , have tended to be rewarded for the risk they have taken³ .

¹ Source: Tversky, A., & Kahneman, D. (1971). Belief in the law of small numbers. Psychological Bulletin, 76(2).

² Bonds are a type of loan issued by governments or companies, which typically pay a fixed amount of interest and return the capital at the end of the term.

³ Source: Vanguard’s Principles for Investing Success.