In the world of psychology, ‘loss aversion’ is the tendency to prefer avoiding a loss over acquiring an equivalent gain. People often cling to what’s safe, familiar, predictable – because we believe losing something we already have would hurt much more than joy we’d feel at gaining something new.
However, as an investor, giving into loss aversion – especially when dealing with the stock market – can have some negative implications for your long-term financial success. Author, philanthropist, and former manager of the Magellan Fund at Fidelity Peter Lynch once said, “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.” My clients have heard that repeated many times over the years.
Here are three things investors give up by giving into loss aversion:
- You deviate from what you want most for what you want now. What you want at the moment might be to avoid perceived danger and to feel safe and comfortable. However, what you want most is to have your portfolio grow in value over time, so you don’t run out of money before you run out of life. When it comes to market volatility and the desire to ‘panic sell’ stocks in a down market, keep in mind that the greater danger is in compromising long-term financial security for the (fleeting) feeling of immediate stability.
- You miss opportunities to be effective. Trying to ‘time the market’ is an ineffective approach to investing and believing that there will ever be a ‘perfect time’ to get back in is a fool’s game. When the going gets tough, you might be tempted to take money out with good intentions to buy when things get better. However, it’s difficult to tell when things are actually “better,” and you could miss opportunities for growth by letting your money sit on the sidelines too long.
- Your perspective is narrower than reality. When you give into loss aversion, you give current activities more weight than they’re worth. A temporary downturn is just that – temporary. It should not prompt an emotional reaction that could have long-term consequences. Good guidance should tell you, “We’ve been through this before, and we’ll get through it again.” Although it’s normal to feel concerned when seeing your assets decline, the reality is that history has shown us the market (and your assets) will come back up in time.
At the end of the day, we humans aren’t rational creatures, and it’s often easier to spot loss aversion in others than it is to see it in ourselves. However, the more you train yourself to recognize loss aversion, the more skilled you’ll become at identifying and combating the inherent biases that keep you from your greatest potential.