Psychology of Investing
Have you ever held on to a bad investment for too long? Are you someone who will do almost anything to win a competition? If so, you’ve experienced loss aversion.
The field of behavioural insights tells us that we will go to great lengths to avoid losses. Loss aversion makes us very sensitive to losses in our lives and pushes us to avoid losses whenever possible. Find out more about loss aversion and how it could impact your financial decision making.
On this page you’ll find
- What is loss aversion?
- What does loss aversion look like?
- How could loss aversion affect your financial decisions?
- How can you protect yourself against loss aversion?
What is loss aversion?
Loss aversion is a common behavioural bias in which the psychological pain of losing something is twice as powerful as the pleasure of gaining it. For example, you’re likely to feel twice as bad when you lose $10 than how good you feel when you gain $10.
Loss aversion is one of the most powerful biases people experience. It is deeply embedded in the chemistry of our brains. It can affect how you protect your property, cheer for sports teams, and assess risk in your financial decisions.
What does loss aversion look like?
Loss aversion can affect almost every aspect of your life. Here are a few examples of where you might notice it:
- Free trials –Many companies offer a free trial to try out their service (e.g., 30 days). They are hoping that the pain you will experience from losing the service after having it for 30 days will push you to keep it and pay for it.
- When buying insurance – Insurance companies outline all of the terrible things that could happen to a person’s property, which activates loss aversion in their customers. Wanting to avoid these events, even though some are extremely unlikely, people pay premiums for insurance coverage.
- Competitions –Whether it be a sporting event, spelling bee, or board games with friends, most people experience loss aversion in competitions. When people expect to win, they will go to great lengths to avoid the pain of losing — and the disappointment of not meeting expectations.
The way you experience loss aversion is not the same in every situation. The intensity rises when the stakes of a decision are higher. For example, you might feel pain when your favorite hockey team loses, but are likely to feel much worse if you lose money on your investments.
Our individual behaviours are prone to bias. That can make financial decisions challenging. Try our behavioural bias checker to understand how biases might be affecting your financial decision making.
How could loss aversion affect your financial decisions?
Loss aversion can affect many areas of your financial decision-making. Here are a few examples:
- Making investing decisions – To avoid losses, many people will refuse to sell stocks or other assets for less than what they bought them for (i.e., in the red) — even if it is a smart investment decision to do so.
- Understanding your risk tolerance –Given that more risk means a higher likelihood of losing money, some people avoid taking on any risk with their investments. They do this even though a responsible amount of risk may earn them a higher return in the long run.
- Managing savings – Every time you decide to manually contribute money to your savings account, you might feel like you are losing money. This perceived loss can make people less likely to save — which will end up hurting them in the future.
Our tendency to avoid losses can lead us to make costly decisions. Loss aversion has a significant effect on our future wealth, as it directly impacts the way we think about saving and investing.
How can you protect yourself against loss aversion?
While loss aversion is one of the most challenging behavioral biases to counteract, there are a few strategies that can help, including:
- Automate your behaviour – You can automate your savings through pre-authorized contributions to pensions, savings accounts, or investment accounts. This can prevent you from experiencing loss aversion every time you decide to manually contribute to your savings.
- Reframe your decisions –Sometimes a loss can actually be an opportunity. For example,when good assets go down in value, the potential loss can be reframed as an opportunity to buy more of the asset at a discount. This can help turn a potentially poor outcome into a long-term benefit.
- Follow your brain, not your heart – Thinking rationally about your finances can help you avoid making decisions based on short-term emotions. One way to achieve this is by working with a registered financial advisor who can help you make objective decisions and put potential losses into perspective.
Learn more about other behavioural biases which might be impacting your financial decisions in ways you may not realize.
Summary
Loss aversion is one of the most common and costly behavioural biases which can impact your finances. Here’s how it works:
- Loss aversion occurs when the psychological pain of a loss is twice as powerful as the pleasure of an equivalent gain.
- This bias is at work in many areas of your life, whether it be the services you use, the insurance you purchase, or playing your favorite board game.
- When it comes to your finances, loss aversion can have a strong negative impact on your saving and investing behaviours.
- There are many effective strategies to counteract the effect of loss aversion. You could automate your behaviour, re-frame your decisions, and use analytical thinking.
