Loss Aversion Bias

Loss Aversion Bias

Loss Aversion Bias 1280 720 Melissa Goodman

The final article in Viridian’s ‘Equation for an Optimal Life’ series, shifts our focus to a behavioural bias that looks at risk as two sides of the same coin – Loss Aversion Bias.

Loss Aversion Bias refers to the tendency to strongly prefer avoiding losses over acquiring gains. The loss felt from losing money or something valuable can make us feel much worse than when we gain the same amount. Loss Aversion explains why uncertainty appears risky and why perceived threats usually take psychological priority over potential opportunities.

This tendency is related to our innate survival instinct of responding more strongly towards threats than opportunities. Except when we only focus on the risks associated with losing rather than the opportunity to gain, it can prevent us from taking even well-calculated risks, with potential for worthwhile returns.

Loss Aversion impacts us in our everyday lives.
How does Loss Aversion impact investors?

Nobody likes to lose and that includes investors! Loss Aversion Bias may encourage some to avoid risk and losses at all costs, even if there is a significant chance of gaining. This fear of losing money can stop people from investing at all as there is risk involved in any investment you make.

Loss Aversion often manifests as Risk Aversion. This may lead those that do choose to invest to have overly conservative portfolios that don’t deliver the returns they need to achieve their goals. It can also push people to sell when stocks are not performing well to avoid further losses, meaning they miss out on gains when the stocks eventually rebound.

Here is an example…
Loss Aversion Bias can affect investors in many ways. Let’s look at how it has impacted Noah.
How do we overcome Loss Aversion Bias?

Loss Aversion comes from an instinctive reflex to avoid pain, making it very difficult for some people to overcome. Additionally, when it comes to investing, a bad experience with money can make people even more cautious. When advising clients, understanding that this bias may be at play is an important first step. From there, an advisor can help clients deal with these emotions surrounding investments.

Loss Aversion can be a major contributor to underperforming the market. Therefore, when it comes to managing this bias, an advisor will set guidelines, targets and objectives for buying, selling, and rebalancing portfolios based on your long-term goals and objectives. Educating clients on the role of risk management strategies in managing market volatility and risk, in conjunction with understanding that targets have been defined, may help reduce this bias. An advisor will also discuss worst case scenarios to put loss in perspective, a simple way to tackle Loss Aversion Bias.

At Viridian, our advisors are equipped to help clients overcome Loss Aversion Bias through education and creating clear targets and objectives. By adding an advisor to the equation, an optimal life can be achieved.

Melissa Goodman is a Portfolio Manager at Viridian Advisory.

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