Phil Patient
Executive Director
If you were given £1,000 to play a game, would you accept:
- A 50% chance to double your money, or
- A 100% guarantee of gaining an additional £450?
If you chose the second option – the guaranteed £450 – you’re not alone. A groundbreaking 1979 study by celebrated author and economist Daniel Kahneman and psychologist Amos Tversky found that respondents were more likely to accept the guaranteed return, despite the higher expected value of the first option.
Their theory of “loss aversion”, summed up by the phrase “losses loom larger than gains”, suggests that humans feel the pain of losses around twice as strongly as the pleasure of gains.
While the Nobel prize-winning Kahneman passed away in March at the age of 90, his theory lives on. Read on to find out why loss aversion can help to explain why investors may be too risk-averse, and how this could hinder your progress towards your goals.
Pains of losses are felt twice as strongly as the pleasure of gains
Despite describing himself as “mostly cheering … from the sidelines” when it came to economics, Kahneman won the Nobel Prize for his work in the field in 2002. His work has become celebrated in a range of fields – indeed, you may have read his best-selling 2011 book Thinking Fast and Slow.
Kahneman’s work was key to the development of behavioural economics, helping to disprove the prevailing theory in the 1970s that economic agents made rational decisions based on the utility, defined in statistical terms, of a particular course of action.
In the late 1970s, he conducted a simple experiment with his students. He told them that if a flipped coin lands on tails, they would lose $10. Then he asked them how much they would need to win to make the coin flip worth the risk of losing $10. The answer, he said, was typically more than $20.
This idea that the pain of losses is felt twice as strongly as the pleasure of gains led to the theory of “loss aversion” – namely that we prioritise avoiding loss more than pursuing gain.
A further experiment cemented this view. Which of these options would you prefer?
- Option A – £1,500 with a probability of 33%, £1,400 with a probability of 66%, and £0 with a probability of 1%.
- Option B – a guaranteed $920.
Kahneman found that most people chose option B. Even though there was only a 1% chance of gaining £0 by choosing option A (and a 99% chance of a higher return), his subjects preferred the guaranteed £920.
3 ways loss aversion could be affecting your investment decisions
Deep-seated loss aversion can result in you avoiding risk and can hinder your progress towards your goals. When it comes to investing, the behaviour can affect you in three key ways.
1. Overly conservative portfolios
If you’re more worried about avoiding losses then you are about achieving gains, it can mean you take too little risk when it comes to investing. You may end up with an overly conservative portfolio that does not deliver the return you need to achieve your goals.
Here’s an example. Over the last 100 years, if you had decided to invest in cash because you were worried about investment losses, Schroders say you would have had around a 60:40 chance of beating inflation. The chart below shows this.
However, had you invested in equities you’d have had a greater chance of your wealth keeping pace with the rising cost of living. Indeed, the likelihood of stock market investments beating inflation reaches 100% for any time period of 20 years.
Source: Schroders
Overcoming loss aversion and taking some risk would have given your wealth a better chance of generating real-terms growth, helping you to generate the returns you needed to reach your goals.
2. Holding on to poorly performing investments
Loss aversion can also lead you to hold on to investments that have declined in value because you want to avoid realising a loss to your portfolio, even when selling would be the prudent decision.
If the “loss” doesn’t count until you realise it, you may be inclined to continue to hold onto losing investments much longer than you should. You may then end up suffering much bigger losses than necessary.
3. Selling during a market downturn
Read the news on any given day and it’s likely that there will be headlines about how much the markets have risen or fallen in the day’s trading.
Short-term volatility in markets can be severe, and so hearing that share prices have fallen can be a powerful contributor to loss aversion. Concerns about the potential for further losses may lead you to cash in equities during a stock market downturn simply to avoid further losses.
However, this essentially turns a paper loss into an actual loss. It also means you miss out on any potential gains as and when the market rebounds.
A study by JP Morgan has found that even missing just a handful of the best market days can significantly reduce your average returns over time. The chart below shows the 20-year performance of the S&P 500 stock index as of 30 December 2022.
Source: Visual Capitalist
As you can see, $10,000 invested in the S&P on 1 January 2003 for 20 years returned $64,844 by 30 December 2022.
However, if you missed just the 10 best days within those 10 years, your return dropped to $29,708.
Loss aversion is a major reason why so many investors underperform the market. In this example, selling stocks out of fear of further losses and potentially missing out on any subsequent market rebound would have cost you more than $35,000 in returns.
Acknowledging loss aversion can help you avoid it adversely affecting investment decisions
As Daniel Kahneman and Amos Tversky found, loss aversion is a deep-rooted human behaviour designed to avoid the feeling of pain.
When it comes to investing, acknowledging that it exists is a useful first step. You could also:
- Try not to check the value of your portfolio too often. Markets are volatile, and noticing short-term dips may lead you to make emotional decisions, which could affect long-term performance.
- Work with a financial professional. They can act as a sounding board and help you to focus on your long-term goals rather than short-term fluctuations.
To find out how we can help you to avoid the disruptive effects of loss aversion, please get in touch. Contact us online or call 020 7400 4700.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
