How loss aversion can set you back when it comes to saving and investing
5 min | 20 November 2023
Loss aversion is a cognitive bias where the pain of losing looms larger than the idea of winning. We take a look at how it can cloud your money-making decisions – and how to handle it.
Have you ever held on to something well past its usefulness? Or maybe you’ve made an overly cautious investment because you’re worried about losing money? Or have you made an impulsive decision when your investments have underperformed? These are all examples of a psychological phenomenon called loss aversion that can affect almost anyone.
What is loss aversion?
Loss aversion comes naturally to us – it’s caring about losses far more than wins. In other words, people feel more pain from losses than feel pleasure from gains of the same size. If you’ve ever had a gym membership and hung on to it long after you’ve stopped going, or kept bidding for something at an auction that you could buy cheaper elsewhere, you’ve experienced something similar to loss aversion.
It explains why people are more likely to try avoiding a loss than they are to earn a gain, like a gambler in a casino who’s on a losing streak and shows no signs of quitting. Instead, the pain of knowingly losing money causes them to bet even more, in the hope they come out on top. So, they double down on a bad bet, rather than cutting their losses.
So, how does this affect our decisions when money is concerned and what can we do about it?
How loss aversion could cost you money
Loss aversion can impact our savings in many ways. For example, if you're used to having a certain amount of disposable income each month, then choosing to pay more into your savings could make you feel like you've got less to spend each month. So you might avoid paying more into your savings or pension, sacrificing a long-term benefit so that you don't feel any short-term loss. As a result, people may not like the idea of increasing their savings or contributions to their pension for the long-term benefit, because they don’t want to experience a more immediate cut in take-home pay.
As people tend to fear loss more than their desire to gain, they may hold on to things for too long rather than moving on and resetting the dial. In an ideal world, you could cancel the unused gym membership and rethink your budget – keeping on top of your spending (and saving) habits.
How loss aversion affects saving and investing
The fear of losing money can lead people to make low-risk choices, like putting money in a regular savings account rather than investments – but these low-risk options could leave them without enough for their retirement. Inflation can make the problem worse, slowly eating away the rate of growth in their savings. The interest paid on savings accounts usually can't keep up with inflation, so savings become worth less as time goes on.
In fact, loss aversion can be one of the major reasons why investors lose money. With the fear of losses so great, they focus more on trying to avoid a loss than on making a profit. It’s natural to be indecisive – and rational to fear losing money – but too much loss aversion can often make people unsure about if/when to invest, what stocks they should choose and how long to ride out fluctuations in the market.
But some investors will hold on to plummeting stock for way too long, because loss aversion can make it difficult to let go if they think there’s a chance it might recover. They might also make unwise investments to try to recover any losses they made (which could end up costing them more).
This happened in 2018. There were two big stock market ‘corrections’ (which is a decline of 10% or more in the financial market) with the typical US investor losing roughly twice as much as the S&P 500. This was largely because investors sold stocks out of fear of further losses, and missed out on market rebounds (when they eventually came).
How to handle loss aversion
Because loss aversion is all about emotions, it’s tricky to catch and beat it. We’re only human, after all. A good approach is to try to stay emotionally detached from your investments by separating your feelings from any choices that you make. You could create your own ‘speed bumps’ that slow down your financial decision-making (like waiting for a few days before taking action, or not). This will give you time to reflect and ensure that you’re not acting impulsively.
Always remember to ask yourself: if I do this, what's the worst that could happen? If you're at all unsure about the right way to invest, consider seeing an independent financial advisor (a human one, not just the internet). This could help you put your feelings of loss into perspective, see the bigger, long-term picture and plan your next move.
Disclaimer: As with all investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you invest.