Unpacking the psychology of loss aversion
It’s natural to avoid loss, but sitting on the sidelines out of fear might lead to missed financial goals.
As the name implies, loss aversion is our instinct to not just prefer a gain over a loss but to prioritize avoiding losses over almost anything. It might sound wise to try avoiding losses but taking it too far could keep you from realizing your financial goals.
Loss aversion is a cognitive bias that studies have proven over and over again. But that fear, when applied to buying and selling investments or strategizing for long-term financial goals, can hold you back. The unwillingness to part with something for less than you paid for it can keep you clinging to declining investments, even selling a “winning” stock to avoid selling another at a loss. It could also make you hesitant to tackle more emotional planning challenges like continuity planning for a family business.
Here are some steps for overcoming the fear of letting go.
- Reexamine your holdings – from investments to real estate to inherited items – with fresh eyes. If you were starting from scratch, which investments would you still want to have? Which investments could you part with?
- Give careful thought to what your true long-term risk tolerance is, and stress test your portfolio. This can give you the confidence to stick to the plan even when conditions or your circumstances get more volatile.
- Look past loss. Instead of dwelling, focus on how moving forward can help make progress toward your goals.
- Study long-term market data: If an investment has lost value, consider the root cause. Is this a case of periodic market volatility, which has historically led to consistent upward momentum over the long run? Or is a particular security no longer an appropriate fit for your financial plan?
- Rely on outside help. Seek out the perspectives of people whose beliefs differ from your own and professionals with specialized expertise. In the case of your financial future, it helps to work with an objective third party – like an experienced advisor – who can offer perspective in addition to wealth planning and investment support.
While it’s natural and often prudent to try to avoid loss, letting that fear loom too large over your financial decisions could actually lead to the very thing you’re afraid of. That’s why counteracting loss aversion by cultivating a healthy relationship with risk could be the key to gaining in the long term.
If you think your loss aversion is affecting your financial goals, consider taking action with these suggested next steps. First, set long-term financial goals that will encourage you to see the bigger picture if you are facing short-term losses. Then, speak to your advisor about the moves you’re thinking about making before taking any immediate action.