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Humans feel the pain of loss over twice as intensely as the pleasure of reward. Although a useful psychological trait for humans in the wild, it can cause problems in the modern world of investing. In particular, fear of loss can cause investors to miss opportunities that might otherwise have grown their wealth.
How can you responsibly manage this bias – “loss aversion” – as an investor? Is it a case of simply ignoring your instincts, or
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What is loss aversion?
If you suddenly won £100 in a prize draw, do you think the exhilaration would be greater – and last longer – than the pain of losing the same amount?
Most people would admit that the latter would feel more “acute” than the former. This dynamic can dictate a lot of human behaviour. Perhaps we do not visit a particular country for fear of experiencing harm (e.g. illness or crime). However, the statistics may not support this loss aversion. Maybe the country simply has a poor media image!
Loss aversion can especially affect financial decisions. Maybe an investor holds onto a stock or fund for too long (hoping it will “bounce back” from a price fall). Or, maybe they do not hold it long enough, engaging in “panic selling” during a volatile market period.
This human tendency can be so powerful that it creates “negativity bias”, which causes investors to lend more weight to bad news than good news. When markets later recover from a short-term decline, investors might crystallise their losses, believing the trend will continue. Conversely, if markets are rising, investors might hold off investing out of fear that markets will imminently collapse.
In the individual’s mind, this is a lose-lose situation!
Why does it happen?
The human disposition to loss aversion partly comes from three parts of our brain – the amygdala (which processes fear), the striatum (which anticipates events) and the insula (which reacts to disgust). These regions may have varying strengths for each individual, leading certain people to experience their associated emotions more acutely than others.
Socio-economic factors are also important. For instance, those in more privileged positions tend to be less averse to losses. This is because their status and networks can “cushion” the potential impact of a loss, thus lowering its perceived risk. Wealthier people may also experience loss more easily. Their additional financial resources act as a “safety net” if things go wrong, giving them more confidence to take additional risks.
Cultural values can also play a role in loss aversion. For example, collectivist cultures – i.e. those which value social connections over individual freedoms – may be less averse to loss if they know friends, family and community are there to help them recover. Individualistic cultures, by contrast, may have less of a social safety net, leading to greater loss aversion.
How do I manage it?
Fear is not completely negative – it can be a useful emotion. It can alert us to danger, both physical and financial. It encourages us to “stress test” different options before committing to a decision. However, loss aversion is not healthy if it governs our lives.
One way to manage this cognitive bias is to build a strong financial protection plan. For instance, having 3-6 months’ worth of living costs ready.
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If you are interested in discussing your own financial plan or inheritance tax strategy with us, please get in touch to arrange a no-commitment financial consultation at our expense:
+34 966 460 407
info@scottsdale.eu