Fundamentals of behavioral finance: Loss aversion bias
Loss aversion drives people to prioritize avoiding losses over earning gains.
Behavioral scientists have found that the pain of a loss is felt more strongly than the pleasure of an equivalent gain.
Loss aversion can lead to portfolios that are too conservative.
This conservative tilt may not give clients the growth potential they need.
By teaching clients about loss aversion, advisors can more easily steer them toward more rational investment decisions.
What is loss aversion bias?
Loss aversion is the tendency to avoid losses over achieving equivalent gains. Broadly speaking, people feel pain from losses much more acutely than they feel pleasure from gains of the same size. Loss aversion bias typically shows up in financial decisions: people often need an extra—and sometimes significant—incentive to take financial risks that might result in a loss.
Nobel Prize-winning economist Daniel Kahneman illustrated how this plays out in a simple experiment he conducted with his students: he told them that if a flipped coin lands on tails, they’d lose $10. Then he asked them how much they would need to win to make the coin flip worth the risk of losing $10. The answer, he said, was typically more than $20.
Why does it matter?
Loss aversion can result in clients avoiding risk, leading to overly conservative portfolios that don’t deliver the returns they need to achieve their goals. It can also push clients to sell during a stock market downturn simply to avoid further losses—which could mean they miss out on gains when the stocks they’ve sold rebound.
Conversely, loss aversion can lead clients to hold on to investments that have declined in value to avoid realizing a loss in their portfolio, even when selling is the prudent decision.
Loss aversion is a major reason why so many investors underperform the market. For example, in 2018, a year that saw two sizable market corrections, the average investor lost twice as much as the S&P 500® Index, according to the financial research company DALBAR.1 This disparity can largely be attributed to investors selling stocks out of fear of further losses, and consequently missing out on market rebounds.
What can you do about it?
Loss aversion is rooted in a deep-seated instinctual impulse to avoid pain. Making decisions before market volatility has a chance to play on clients’ emotions can help keep them from making emotionally charged decisions. Work with your clients to set up guidelines and objective rules for buying, selling, and rebalancing, particularly when facing difficult market conditions that require a more systematic approach. For example, agree that you won’t sell a holding unless it falls by a certain percentage.
Additionally, consider suggesting to clients with an especially strong emotional bias to go on a media diet. The financial media tends to focus on dramatic short-term ups and downs in the market rather than longer-term performance trends. Staying clear of the financial news can help keep clients from experiencing the fear that leads them to make harmful short-term decisions.
Omar Aguilar, Ph.D.
Senior Vice President,
Chief Investment Officer, Passive Equity and Multi-Asset Strategies
Charles Schwab Investment Management, Inc.