The Aversion to Loss
The Aversion to Loss, or more commonly known as Loss Aversion is an important behavioural finance concept that is effectively summed up by psychologists Kahneman & Tversky that “losses loom larger than gains”.
The best way to describe this is to imagine you’re walking down the street and you see 20p on the floor, do you pick it up and stick it in your pocket and walk off? Think again, this time you drop your own 20p on the floor. Do you stop your walk, bend over and pick YOUR own 20p back up?
Research suggests that most people will leave the 20p that is effectively not theirs but almost everyone will stop and pick up the 20p that they’d initially dropped, despite the fact that the net gain or loss is exactly the same. This is called loss aversion.
Imagine the following: you and a mate flip a coin. If it lands on heads, then they give you £50. Tails and you owe them £50. Would you take that bet? Research around loss aversion indicates that most of us completely irrational humans wouldn’t be interested in taking it on because we typically would want potential returns of at least twice the amount we were willing to lose.
In theory, and in reality, losses have a far greater psychological impact on us than equivalent gains will ever realise. Almost to the level of 2 to 1. Of course every individual case is different, as the research is a blanket for the many, and part of our job is to ascertain exactly how it would affect our clients and their families.
This is really important to understand when it comes to us talking to our clients about money and investing. There are some simple ways to approach the whole conversation and consideration of “risk” and part of our job is to understand how this can mean different things to different people, and to help to put it all into perspective for our clients.
It is of paramount importance to us - as it is to the client – that we understand how they would react to losses vs the feelings they might experience when their investments make a profit so that we can accurately gauge what their aversion to loss really is.
What loss aversion scenarios have you experienced?
Alfie Mullan, December 2019