What is loss aversion?
Loss aversion is a form of cognitive bias which is the tendancy for irrational actions because of an inability to process information in an objective way. It’s especially common during financial decision-making and helps explain why some investors focus more on trying to avoid losses than making gains to the point where some may not invest at all.
According to MasterClass, the term loss aversion first appeared in a 1979 psychology research paper by Daniel Kahneman and Amos Tversky. Kahneman's later work on economic behavior earned him the 2002 Nobel Prize.
Some examples of loss aversion include:
- Refusing to sell your house for less money than you paid for it
- Not selling an investment that’s below the price you bought it for because you don’t want to lose money
- Selling an investment when it’s worth more than when you bought it just to take the profit
The psychology of loss aversion
According to The Decision Lab, 3 things in our make-up may cause loss aversion:
- The way our brains work – Our brains and bodies are programmed to fear losses more than seeking gains.
- Socio-economic factors – Powerful, wealthy people are less loss averse because their status, network and wealth allows them to be in a better position to manage loss if it happens.
- Your culture – People from African countries are the least loss averse because their culture is more like a collective and they can turn to close social connections from friends, family and community. Those from eastern European countries are often more loss averse because their culture is more individualistic, values close relationship less and lacks the same social safety net.
How to deal with loss aversion
There are several strategies you can use to manage loss aversion:
- Framing – Try looking at the potential gains of a transaction rather than the risk
- Put loss into perspective – Ask yourself what the worst outcome would be if you take an action as a way to rationalize if it’s worth taking.
- Understand your comfort with investment risk – Take an investment personality survey to learn about your risk tolerance
- Create an investment plan – Determine your investment goals and how you’ll achieve them to help keep you focused when faced with market volatility and make you less emotional about it.
- Work with an advisor – This can help you feel more comfortable with your investing no matter how it’s performing.
- Consider investments that help defend against extreme market swings and minimize losses during periods of market volatility.