Here are three ways in which loss aversion leads to clients making irrational decisions on their investments.
The psychological impact of a particular loss is considerably stronger than the impact of an equivalent gain. Psychologically, the ‘pain’ of a loss is felt twice as strongly and aversively than the ‘pleasure’ of an equivalent gain. This leads to overweighting of losses.
Loss aversion is perhaps one of the most pervasive elements of irrational decision-making. Our ingrained tendency to overweight losses can be related to a host of further judgmental biases that impact on financial decision making.
Sunk cost effect: where people are seemingly willing to continue their commitment to a failing course of action i.e. ‘throw good money after bad’, rather than give up on the action and realise the losses.
Disposition effect: where investors hold onto losing stocks longer than they should, whilst also tending to sell winning stocks prematurely. This tendency can reduce returns on investments.
Myopic loss aversion: where people tend to evaluate a series of risky options in singular rather than aggregate terms, so evaluating a portfolio of investments item by item rather than as a whole; this leads to a very risk adverse strategy that reduces returns.
Bambooing is here to help…
We believe that this area is an important area to understand and loss aversion is build as a core element of our digital tool Bambooing.
This is because loss aversion should be measured against a person’s subjective attitude to risk (or in traditional speak, their ATR). Subjective attitude asks questions such as “what would you do if…?” The problem with asking investors what they would do in a future state is they can’t answer with any degree of accuracy. To do this we need to be in our environment with all the stimuli around us to make an informed decision.
If you ask a person what they think they’d do (ATR) and match that to their loss aversion you get a really interesting measure. What you get is whether their self-perception of what they’d do is balanced or not. What happens if you speak to a client who thinks, through an attitude to risk, that they are high risk but their behaviour is screaming absolutely not high risk and they’re more cautious?
When the portfolio goes down and they start to lose money, that behaviour (loss aversion) is going to trump subjective attitude every single time.