Why Losses Loom Larger Than Gains

Money Energy Law #14:

Know your acceptable level of loss aversion. Set your boundaries to stay emotionally balanced.

It's interesting to note that all investors value gains and losses differently. Loss aversion is the predisposition to avoid losses over equivalent gains. In other words, some people feel pain from losses much more acutely than they feel pleasure from gains of the same size. All of us have different levels of loss aversion based on our unique DNA behavioral style.

A Quick History Lesson

Some say loss aversion is the foundation of all behavioral economics. Perhaps you have heard the names Daniel Kahneman and Amos Tversky? They were two brilliant and curious-minded individuals who explored psychology starting in the late 1950s and early 60s. In the spring of 1969 these two met and explored cutting-edge experiments about how people learn from new information. Together, they published a series of groundbreaking and influential articles in the general field of judgment and decision-making that culminated in the establishment of Prospect Theory in 1979. Loss aversion is the brainchild of that theory.
 
It’s easy enough to say that investors can avoid such psychological traps by adopting a strategic investment strategy, or reasoning, and not letting such fears influence your financial decision-making. But I ask you, were you ever tempted to sell an investment that went up slightly in value just to realize a gain of any amount? Or perhaps you chose to buy a low-return, guaranteed investment over an investment with more risk but a far more promising performance in the long-term. And what about the opposite? Ever hold onto a stock that rational financial analysis clearly indicates you should sell, but just can’t accept the loss? Maybe you even tell yourself it is not a loss until it is realized.

The reactions you feel form a part of your financial behavior, your identity, and your money energy. They are not unhealthy reactions, merely a chaotic Financial EQ that can be revealed, measured, and managed. In fact, loss aversion is hard-wired into us. Let’s face it, the last thing we like doing is admitting that we are wrong or need to cut our losses.

The first step to understanding and managing any cognitive bias is to accept that you have it. Once understood, recognize that loss aversion can impact decisions resulting in poor decision-making (regardless of whether money is involved). Remember, the fear of losses prevents us from taking even well-strategized risks that can yield excellent returns.

Risk Aversion vs. Loss Aversion

It’s important not to get risk aversion and loss aversion confused. They sound alike, but they have different meanings. A risk-averse investor may consider two investments with similar returns. If one is riskier than the other, they may accept greater risk if they feel compensated for it (i.e. potentially higher performance). Otherwise, when given the choice, the risk averse investor will choose the one with less risk. Another example of this would be someone who prefers to deposit money in a bank with a low, guaranteed interest rate rather than buy a stock that can fluctuate in price despite the potential.

To understand loss aversion, we need to review its three key principles:

1. People will exhibit more risk avoidance or more risk seeking depending on the nature of the series of potential wealth outcomes.

2. The valuations assigned to those wealth outcomes depend on the perceived gains and losses relative to some form of reference point or prevailing assumptions.

3. People generally avoid risks because losses loom larger than gains in our minds.

You may wonder what is driving this unwanted emotion that results in loss aversion. It is derived from our “Financial DNA” (i.e. your financial personality), which is a key component powering our level of Money Energy. There are a few steps you can take to reduce the influences of this bias.

First, which I am hoping to accomplish as you read this is to be aware and prepared. Just knowing your tendencies is powerful knowledge. Second, always try to take a third person view of the situation and evaluate whether your actions are feeding or reducing opportunities to generate wealth. (In other words, is your action or lack of action a good use of your time and money?) And third, have a clearly defined internal statement about your acceptable personal level of loss aversion. Let’s call it the ‘go, no go.’

The DNA Natural Behavior Discovery Process is an easy way to gain awareness of your financial personality. With this wealth of insight, you can easily set your ‘go, no go’ in terms of your decisions and resist the temptation to sell too soon or hang on too long.

A Case in Point

Michael Rodriguez is 38, single but engaged to be married. He works in a government department, and even though his salary is good at this level, he still struggles to have enough to purchase his first home. 

Michael has an Engager DNA Style with strong spontaneous and outgoing traits. He is well-liked, flexible, and willing to step up to anything needed. Making a good impression matters to Michael and, to that end, he has made fast and often wrong decisions to seek approval from others rather than spending more time thinking through how to apply his skills to understand what drives his decision-making financially and in other areas of his work life.

Michael has a reasonably balanced, safe investment portfolio but speaks to his advisor about the need to ramp things up a bit to buy a home. After conducting investment research, seeking opinions from trusted friends and resources, and with his advisor's help, he diversifies some of his investment into a higher return, which is a riskier but sound investment. 

A few months later, Michael sees the stock rise slightly. And, against his advisor's advice, emotionally decides to sell early in favor of the small profit he will make rather than stay the course in terms of building a sufficient sum toward the purchase of a home. It’s a classic case of loss aversion. 

Fast forward several months later, the investments soared, just as his advisor and research had predicted. Had Michael been able to avoid his loss averse impulses, he would have attained his goal sooner and had enough capital to purchase the home now rather than further down the road.

The question you must ask yourself: “Would I have fallen into the same trap?” Hopefully you won’t, now that you know more about this behavioral risk.

Stay tuned every week as we continue to reveal all 40 Laws of Money Energy.

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