Loss Aversion | Behavioral Finance

Behavioral Finance | Loss Aversion

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Are you too attached to let go?

Loss aversion. It’s what leads people to hold onto items long past their usefulness and to refuse to part with others until they get what they paid for them. It might sound wise to try avoiding losses, but taking it too far could keep you from realizing your financial goals.

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What is loss aversion?

As the name implies, loss aversion is our instinct to not just prefer a gain over a loss, but to prioritize avoiding losses over almost anything.

It helps drive the comforting appeal of sticking to the status quo, and is often why those who have experienced or witnessed significant financial loss due to a market crash or recession may be less likely to invest.

Our aversion to loss can be felt across many aspects of our lives – making it difficult for us to part with everything from threadbare sweaters to underperforming investments. In fact, research has shown that we often believe items we own are worth more than identical items we don’t – simply because we own them.1

But more than just causing you to miss out on opportunities, loss aversion can actually open you up to risk. The fear of loss – which several studies have suggested is twice as powerful, psychologically, as the good feelings generated by gains – is so strong for some that they will make bad decisions simply to avoid it.2

Loss Aversion = Lost Potential?

Money is frequently one of the things people are most afraid of losing, which means loss aversion can become even more influential – and potentially damaging – when it comes to your finances.

A 2007 study conducted by Russell Poldrack, a professor of psychology at Stanford University, monitored participants’ brains when presented with potential monetary gains and losses. And while he and his colleagues found that brain activity was heightened by both possibilities, it was markedly stronger when participants faced losses.

That fear, when applied to buying and selling investments or strategizing for long-term financial goals, can hold you back. The unwillingness to part with something for less than you paid for it can keep you clinging to declining investments, even selling a “winning” stock to avoid selling another at a loss. It could also make you hesitant to tackle more emotional planning challenges like continuity planning for a family business.

When loss aversion factors into your financial decisions:
  • You might hold on to investments that keep losing value because you refuse to sell below a given amount, or put off uncomfortable conversations around disability, long-term care and legacy planning.
  • You might hold on to possessions – or investments – that were gifted to you, even if they’re aren’t the best fit for lifestyle or goals.
  • You might operate too fearfully and miss out on opportunities based on a past negative experience, like a market crash or a saving goal you fell short of.
  • You may take on unwise risks to try to counteract an existing loss.

Too strong an aversion to loss can hinder a financial plan’s progress. But it doesn’t have to be what holds yours back.

How you can let go of loss aversion

  1. 1. Look at your holdings – from investments to real estate to inherited items – with fresh eyes. If you were starting from scratch, which would you still want to have? Which could you part with?
  2. 2. Give careful thought to what your true long-term risk tolerance is, and stress test your portfolio. This can give you the confidence to stick to the plan even when conditions or your circumstances get more volatile.
  3. 3. Look past loss. Instead of dwelling, focus on how moving forward can help you keep progressing toward your goals.
  4. 4. Look at long-term market data: While events like the financial recession and dot-com bubble were extremely significant at the time, when seen in context of a longer time span, they were temporary speedbumps in the consistent growth of the market.
  5. 5. Look for help. Seek out the perspectives of people whose beliefs differ from your own and professionals with specialized expertise. In the case of your financial future, it helps to work with an objective third party – like an experienced financial advisor – who can offer perspective in addition to wealth planning and investment support.

While it’s natural – and often prudent – to try to avoid loss, letting that fear loom too large over your financial decisions could actually lead to the very thing you’re afraid of. That’s why counteracting loss aversion by cultivating a healthy relationship with risk could be the key to gaining in the long term.

According to one post-Great Recession study, respondents who'd experienced losses were 1.5 times more likely to switch to cash when they didn't need to.4
One in 11 Americans pays an average of almost $100 per month for self-storage, often taking on the expense to hang onto sentimental but unused items.5

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