Want higher investment returns, better control of your expenses, and a simplified life?
A strong understanding of loss aversion will help you detect and mitigate its negative effects on your financial life. I think it’s a very cool concept, due to its broad applications to personal finance and life.
You (and me) feel the pain of loss about twice as intensely as the pleasure of a similar gain.
“Losses loom larger than gains”.
The strong pain of loss does funny things that can hurt you financially. Here are some specific examples:
- Panic selling investments during a market crash.
- The desire to invest in speculative investments that have had high recent returns (FOMO).
- Making it difficult to get rid of things you own, resulting in clutter, less free time, and more lifestyle complexity.
- The difficulty in cutting back on lifestyle spending.
You may be wondering, “How do I prevent loss aversion from hurting me financially?” Here is the sequence I find most helpful:
- Understand what loss aversion is, and how it affects you financially.
- Control your environment to limit influences that trigger loss aversion (protect yourself from yourself).
- Exercise self-discipline so that you do not act on the natural emotions triggered by loss aversion.
Table of Contents
What is Loss Aversion?
Losses are more powerful than gains.
A loss hurts about twice as much as an equivalent gain is pleasurable. For example, the pain of losing $50 is about twice as great as the pleasure of gaining $50.
This causes us to go to great lengths to avoid losses. You and I are loss “averse”. It’s a normal human response that has been baked into your phycology through natural selection; it’s nothing to be ashamed of.
In the plot below (Kahneman et al, 1991) you can see that the slope of the line is steeper for losses than it is for gains. The disutility per unit of loss is greater than the utility per unit of gain.
Loss Aversion: The Baseline
All losses are measured relative to a baseline.
Fascinating ideas arise when you consider that losses must be measured relative to a reference point. For example, one person’s loss can be another person’s gain.
One Person's Loss: Another Person's Gain
Consider two recent university graduates, George and Fred, who get hired at similar jobs making $60,000/year. They each buy a 10-year-old civic for $6,000. What a coincidence.
Following graduation, financial help from their parents stops on the date of graduation. They live of their salary only.
- George grew up in a low income family, has never owned a car and his parents never provided financial assistance in university. The 10-year-old civic is his first car.
- Fred’s parents paid for a leased BMW 3-series throughout university, but now that parental funding has stopped, Fred can no longer afford the 3-Series. He downgrades and buys a 10-year-old civic.
George and Fred buy the same car, but George views the new car as a gain whereas Fred views it as a loss. The same purchase caused George pleasure and Fred pain.
And since humans feel pain of loss as larger than gains, Fred’s feeling of pain is far more intense than George’s joy.
Fred and George had different reference points. Different baselines.
Loss is must be measured against a reference point, and this reference point is often external such as lifestyle, income, material wealth, or social status.
Absolute Vs. Relative Loss
The above example showed that losses are often relative, not absolute. This applies directly to investing.
A $1,000 loss will hurt more to a person with a net worth of $10,000 than it will to a person with a net worth of $1,000,000. In the first case, the loss is much larger relative to the baseline.
When considering investment losses, it’s natural to use percent drop as a metric. A 50% drop in portfolio value, for example. This is good because the drop is already measured relative to the reference point of portfolio size.
But there are more considerations for setting a baseline. For example, how big is the portfolio relative to your annual income? And how much of your net worth is tied up in that portfolio?
The answers to these questions will give indicators of how much pain you feel during market crashes.
A Biological Basis for Loss Aversion
You are biologically wired to detect and avoid threats/loss.
It’s etched into our neural circuitry, as indicated by this study that looked at two people with lesions to the amygdala. They both showed lower loss-averse tendencies in response to monetary loss.
I’ll show how a loss-averse brain can be useful. Assume you have 2lbs of food and you live in a forest with nothing around; this was the norm just 10,000 years ago.
Lose a pound of your food and you will likely die. Gain an extra pound of food and you will be marginally better off. At worst, the food will be difficult to carry and won’t last long. At best, the extra food can be shared with others who can reciprocate back in the future.
A loss of food was worse than a similar gain in food.
Our ancient biological systems remain to this day, even though we don’t roam in 100-person tribes anymore. If you have shelter, food, and water, chances are that loss aversion doesn’t serve utility to keep you alive.
Loss Aversion: How It Can Hurt Investment Returns
Loss aversion motivates FOMO and panic selling, causing investors to buy high and sell low. Sounds like a good formula to lose money.
In good markets, loss aversion fuels Fear Of Missing Out (FOMO), producing a desire to buy speculative assets at the worst possible time.
And in bad markets, you become fearful as losses bite, producing a desire to panic and avoid the discomfort of the loss.
Awareness of your normal loss-averse tendencies can increase your willingness to take risk so that you can reap higher long-run returns. Learn more about the relationship between risk and returns in this post.
I won’t cover specific ways to mitigate loss aversion when investing here, because it’s covered in my post on 7 Ways to Control Investing Biases.
Bull Markets: FOMO
When bitcoin was going to the moon, I felt like I was missing out. Everyone was reaping high returns, and I remained in my boring old Index Funds.
When you see others making high (short-term) investment returns, the baseline has gone up. Your returns, although unchanged, are going down relative to the average returns of the herd.
Missing out on gains feels like a loss. You will be motivated to do some weird things to avoid the loss. Buying speculative assets with high recent returns. With prices sky high, you can expect low future returns. You paid too much for the asset due to FOMO, driven by loss aversion.
Maximum FOMO occurs at the peak of the asset bubble when future returns are lowest.
Sometimes, these assets have no fundamental value, like bitcoin or Tulips. Other times, the underlying business may be good, but you pay an excessive amount for its underlying earnings.
To see why high asset prices are a formula for low returns moving forward, you can read Where Stock Returns Come From.
Bear Markets: Panic Selling
Any investor in 100% stocks, no matter how diversified, should expect to see a 50% crash at some point in their investing lifetime. That’s clear when you look at the past 30 Years of Stock Market Pains and Gains.
Successful investors, hold through crashes, without selling.
Thanks to loss aversion, you feel pain during market crashes. To avoid the pain, your natural response will be to sell to prevent further loss.
Your desire to sell peaks at the depths of the market crash, exactly the same point of maximum future returns. The loss aversion bias urges you to sell investments at exactly the time when it is best to remain invested. That’s fascinating.
It’s also worth considering that aggregate investors are loss-averse. Therefore, they over-sell when acting on their loss-averse emotions, and prices are depressed further than is rationally necessary.
Depressed prices present a buying opportunity for those who can constrain and battle their loss aversion bias. Those who can deal with their loss-averse tendencies will be rewarded.
Losses: Portfolio to Income Ratio
Losses are measured to a reference point, such as income, or total net worth. For young investors, income is a solid reference point, and it can be measured by your portfolio-to-income ratio.
Say your portfolio value is equal to 1 month worth of income and there is a 50% stock market crash. You can earn back the loss with just 2 weeks of work.
A portfolio equal to 2 years of income is different. You’d suffer paper losses equal to one year worth of income at the bottom of a 50% downturn. That induces more loss aversion pain because losses are relative.
The larger your portfolio value relative to your income, the more a given % loss will induce loss aversion pain.
Loss Aversion and Frugal Living
Loss aversion can make it more difficult to live a frugal life.
Frugal living is great for money savings, but I find the real value comes from the time and energy savings, as described in this post.
Therefore, loss aversion can get in the way of the preservation of time and energy. There are two main ways that loss aversion can make frugal living more difficult:
- Lifestyle Creep. Cutting back on spending feels like a loss and triggers pain. Loss aversion teaches you that it’s much less painful to prevent your spending from increasing in the first place. Prevention > correction.
- Endowment Effect. Departing with goods you own feels like a loss. Therefore, you are more likely to accumulate goods, reducing your time and energy. This is the endowment effect.
I’ll cover the influence of loss aversion on the endowment effect and lifestyle creep in more detail.
Loss Aversion and The Endowment Effect
The endowment effect is the tendency to overvalue things we own. “People to require more to give up an object than they paid to acquire it (Kahneman et al, 1991). Another way to look at this is that we develop an emotional attachment to the goods we own.
To get rid of an item you own, you must let it go. That’s a loss. And losses hurt more than gains.
Naturally, loss aversion will leave you with more “stuff” than necessary.
Lots of stuff imposes time requirements to organize, clean, and conduct maintenance. Plus, I believe there is a physiological effect where a cluttered environment correlates to clutter in your mind.
One must battle the endowment effect to facilitate Frugal Living and simple life.
Loss Aversion and Lifestyle Creep
A high income is only useful if you know how to use it, as I describe in the two most important factors to grow wealth.
Lifestyle creep is a natural phenomenon where expenses creep to match income. It is the reason why many high earners remain shackled to a paycheck-to-paycheck life while failing to grow net worth.
An increase in spending (lifestyle creep) gives you a jolt of temporary pleasure. You then quickly adapt and revert back to your baseline level of happiness, hedonic adaptation. But now your baseline for spending has increased, and reductions from this baseline will bring about a loss.
Because losses hurt more than gains, it is far more painful to reduce our spending than it is to prevent our expenses from creeping up to an unhealthy level in the first place.
The key lesson is that the best way to approach lifestyle creep is through prevention, not correction.
Loss Aversion: Minimalism and a Wealthy Life
Once you have essential expenses covered, further increases in lifestyle spending result in temporary pleasure and quick adaptation.
The only long-term change is that your reference point for loss is now higher. You are more susceptible to the pain of loss aversion.
The more you rely on easily adaptable external sources for wellbeing and identity, the more fragile and less resilient you will be in the face of hardship.
Examples of external sources of wellbeing/identity include material goods, social status and followers. Not only do you adapt to these items, but they are often outside of your control and can easily be taken away.
These things are only bad if they are the core staples of wellbeing or identity. I feel that identity must be rooted strongly in internal factors that cannot be lost, such as strength of character and a capacity to endure hardship.
Frugal living clearly reduces vulnerability to loss aversion. Plus, there are many ways to spend to bring you sustainable wellbeing, as I cover in Money, Happiness and Wellbeing: The Ultimate Guide.
This theme of frugal living as part of a good life is nothing new. Minimalism is a theme of the Stoics, who seem to have figured this out thousands of years ago.
Conclusion
The concept of loss aversion was planted in my head while reading Thinking Fast and Slow by Daniel Kahneman. Since then, loss aversion has been on my mind, as it has broad applications to personal finance and life.
- Loss aversion motivates irrational decision-making such as panic selling and buying speculative assets.
- The pain of loss makes it hard to depart with items you own, resulting in natural hoarding tendencies.
- It is harder to reduce lifestyle spending than it is to keep spending low from the get-go.
References
Kahneman, Daniel, Jack L. Knetsch, and Richard H. Thaler. 1991. “Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias.” Journal of Economic Perspectives, 5 (1): 193-206.
B. De Martino et al (2010). “Amygdala Damage Eliminates Monetary Loss Aversion” Proceedings of the National Academy of Sciences.