Loss Aversion
Every birthday, my mom gives me a scratch-off lottery ticket. This year I won $100.
I cashed it in and used the money to order a nice dinner for my family. We were all pretty happy about it.
Then I forgot about it.
Last week, I went to fill up my gas tank and as I was reaching into my wallet, I noticed a $50 bill missing.
I spent the next two days thinking about where I could have lost it.
Somehow the feeling of losing $50 outweighed the feeling of winning $100.
This got me to thinking about how some of my clients feel when they think about investing.
After years of getting to know them, I realize that most of them would prefer not losing $50 than making $100 in their portfolio.
There’s a theory in behavioural finance that addresses this feeling: Loss Aversion.
Research shows that most investors feel the pain of a loss twice as much as the joy of a gain[1].
These negative feelings can lead investors to make strange decisions, such as not selling a stock that has gone down in value so they don’t “realize a loss”, even though their analysis suggests it is not likely to go back up. Or purchasing guaranteed investments even though the return is much lower than what they could potentially get elsewhere.
When investing for the long-term, one of the most beneficial habits we encourage our clients to build is to look at their statement less often.
When you look at your statement every day, the likelihood of seeing a gain stands at about 54%[2], which leads to more bad emotions than good emotions. If, however, you look at your statement only once a year, your likelihood of seeing a gain increases to 93%[3], dropping your chance of feeling those bad emotions to about 1 in 10.
This habit, as well as our regular contact with them, has helped many of our clients weather the storm during market downturns since they were not tempted to sell their investments in order to “stop the bleeding”.
In hindsight, they have been very thankful for it as they avoided making emotional decisions to sell at a loss and potentially miss the ensuing market rallies.