Loss aversion: The psychology behind it, and how it can derail investment returns
Humans are hard-wired to avoid losses, a concept known as “loss aversion”. Here’s how loss aversion works and why it could derail your investment returns.
Do you lament life’s negative aspects more than you celebrate the positives? As it turns out, you might be wired that way.
Back in 2018, the University of Sussex did a study with the participation of 32,000 football fans, asking them how they felt when their team won, versus when they lost. The researchers discovered that for those who love the beautiful game, the pain of seeing their team lose was felt twice as intensely as the joy when they win.
Interestingly, this doesn’t just apply to football – or any sport for that matter. Nobel Prize winning psychologist, Daniel Kahneman, studied this concept and named it “loss aversion”. It’s the idea that we avoid the potential for loss at any cost, because as humans, we feel our losses more deeply than our gains.
The below graph gives a visual representation of how much value we place on gains, versus the value that losses represent to us.
Source: The Decision Lab
When it comes to your wealth, loss aversion may protect you in many ways. It could make you more savvy about how you spend money. Plus, it may help to ensure you’re taking out the relevant financial protection to avoid losing wealth unnecessarily.
However, when it comes to investing, Daniel Kahneman’s theory of loss aversion, also known as the Prospect Theory, could have a negative impact.
Keep reading to discover how loss aversion might affect your investing behaviours, plus how financial planning might help you to make objective decisions.
Loss aversion could prevent you from pursuing potentially lucrative investment opportunities
Investing in the stock market is an important aspect of any robust financial plan. But it’s understandable that you might be nervous about losing your hard-earned money if markets experience downswings.
You might have seen that in August 2024, markets experienced a widespread selloff prompted by concerns over investing conditions – and this is just one example of loss aversion in action.
A study by Wealthify says that 66% of Brits are nervous about investing, with 50% saying the risks outweigh the benefits. While there is often a risk of losing capital when you invest, your nerves might play into Kahneman’s Prospect Theory.
Loss aversion goes back to the beginning of humankind. Thousands of years ago, losing your crop might have meant your village went hungry. Or, an injury may have caused you to be too weak to defend yourself from predators.
The “hangover” from this very real, very important form of loss aversion means that you might feel equally concerned about investing. This feeling could persist, despite the historic data showing that markets usually bounce back from losses over the long term.
Take a look at the below graph, depicting the performance of the FTSE 100 index between August 1984 and August 2024.
Source: London Stock Exchange
As you can see, the index has experienced some significant downswings, especially in the early 2000s and during the Covid-19 pandemic.
But over the 40-year period, the FTSE 100 has grown in value by almost 700%. The Guardian reports that with dividends reinvested, £1,000 invested in this index in 1984 would have been worth £22,550 in January 2024 – despite the value of your portfolio fluctuating quite dramatically over this time period.
Put simply, loss aversion could prevent you from trusting the long-term gains you could see when you invest.
With a little patience, a data-driven investment strategy, and the nerve to ride out some of the markets’ most turbulent storms, you could grow your money and reach your goals more quickly than just sticking to cash.
You may be more likely to panic-sell investments that dip in value
There is another investing behaviour that could be explained by Daniel Kahneman’s theory of loss aversion: “panic selling”.
Panic selling describes an investor seeing that the value of a holding has decreased, and immediately cutting their losses and selling it off. This epitomises loss aversion: to avoid losing even more wealth, an investor crystallises those losses by selling off the asset altogether, leaving no opportunity for it to regain value.
If you’re faced with a dip in portfolio value – which can happen several times in one year, or even in one month – it’s important to curb your loss aversion. If you panic and solidify those losses, your wealth could be affected over the long term. On the other hand, as the above FTSE 100 graph shows, historic data reveals that markets typically recover and post positive returns over a long-term time frame.
Independent financial planning could help you combat your loss aversion mindset
You may have slipped into a loss aversion mindset without even realising it, and if so, you could be inadvertently hampering your investment growth.
Being nervous about investing in the first place, or panic-selling investments that don’t perform well in the short term, could both be signs that you’re letting loss aversion control your investment behaviours.
If this is a behaviour you recognise, we can help.
Our independent financial planners can help you create a data-driven investment strategy that motivates you stay invested throughout any volatility that happens along the way. We’ll spend time talking to you about your life goals, and work with you to create a portfolio that produces the kind of results you’re seeking.
To discuss how loss aversion might affect your investment strategy, and to find an alternative route for building wealth through investment, get in touch.
Email us at hale@kelland.co.uk, or call 0161 929 8838.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.