How Loss Aversion behaviour can destroy your wealth

By Larissa Fernand |  03-03-20 | 

We spend a huge amount of time trying to make smart decisions with our money. It is possible that we could add just as much value—if not more—by avoiding dumb ones.

You, as an investor, must get acquainted with Loss Aversion.  It holds that all else being equal, losses fundamentally loom larger than gains. 

Morningstar's experts explain this brilliantly and tell you how to deal with it.

DAN KEMP, CIO – EMEA, Morningstar Investment Management

People talk about risk aversion. But there is also something call loss aversion.

It is not that people don't like taking risks. What people don't like is losing things. We feel losses twice as keenly as we feel gains. So, we hate losing Rs 100 as much as we like making Rs 200.

People that go into casinos can validate that when you go in at the start of the night, people tend to spend their chips at the roulette table very carefully, and try and lose money as slowly as possible. But when they get to the end of the night, they just have a few chips left in their pocket, they tend to go for really high risk bets. So, people move from being risk averse at the beginning of the evening when they have lots and then when they've lost that money, they become risk seeking because they're trying to get it back.

This same behaviour gets replicated in investing.

When people see a stock falling in price or their portfolio falling in value, they feel that they've got to stop losing money. That leads to people selling investments when there's just a small dip in prices.

Equally, if you have a real loser on your hand, suddenly, let's say, fallen by 80%, then people are normally very keen to hang on to it. That even if everything is going wrong, they don't want to sell it at that point, because they're hoping it will get back to the value that they started with.

Something that I find helpful to remember is that an investment that's fallen by 90% is one that's fallen by 80% and then halved. So, actually, loss aversion can really hurt you, not only when you're taking small losses, but also when you're refusing to take big losses.

The key thing is that people tend to want to cut those losses early, which is why the ups and downs of the market causes so many problems. But also, often they sell things that are going well, too early, as well. And so, both sides of the coin can hurt people.

Stop looking at your portfolio frequently.

Write your strategy down and revisit it when the market turns volatile. Talk to your adviser before acting.

BEN JOHNSON, Morningstar's director of passive funds research

A big mistake people make is that they pay too much attention to their portfolio.

Our most meaningful investment milestones are decades away, but our attention is monopolized by the moment. Paying too much attention to our invest­ments today can put us at risk of missing goals that are years away.

One of the chief side effects of monitoring our invest­ments too closely is that it fuels our aversion to loss. Loss-aversion is but one suitcase among our abundant evolutionary baggage.

The theory is that we feel far greater pain from losses than we experience pleasure from gains of equal magnitude. The tie to evolution is that Fred Flintstone had far greater incentive to avoid being mauled by a saber-toothed tiger than to order another oversize rack of ribs from his already-toppled car.

Loss aversion can have a meaningful impact on investor behavior.

In “Myopic Loss Aversion and the Equity Premium Puzzle,” Shlomo Benartzi and Richard Thaler demonstrated that the disconnect between the duration of investor’s goals (retiring 30 years from now, for example) and the frequency with which they monitor their portfolios (typically at least once a year) leads to a behavior they coined “myopic loss aversion.” The likelihood of losses in any given 1-year period is far greater than the probability of losing money over a longer horizon. But the authors found that annual reviews led investors to behave as if their investment horizon was a year out and not 10 or 20 or 30. This leads many to take less risk (by allocating less to stocks, for example) than is necessary to meet their longer-dated goals.

The best way to shake this behaviour is to simply stop paying so much attention to the markets and our portfolios.

I am a firm believer in an approach to port­folio monitoring and maintenance that borders on benign neglect. There is so much noise in the markets that the signal typically fades into the background. Tuning out the noise will also help to diminish the illu­sion of control and recency bias.

In recent years, I personally have made a habit of only looking at my own investments once every few months or so. I’ve found that every time I turn up the volume knob on the market’s noise-making apparatus, it’s tempted me to tinker with my portfolio.

While it’s tough to put the market on mute, I think we’d all be better served by tuning out a bit more often.

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