When it comes to investing, we human beings are a curious bunch. Logically, we understand certain principles, whether it be the need for diversification or the importance of owning equities for the long-term.
But so often, we are not impartial, rational actors. Rather, the human mind is afflicted with what are known as cognitive biases. Per the encyclopedia Brittanica, these are “predictable patterns of error in how the human brain functions”.
Put another way, cognitive biases skew our perception of reality, tilting us away from what’s objectively true. And they can lead us to make decisions that aren’t in our best interests. Think of these biases as wrong directions that influence our behaviour.
Case in point: Loss Aversion, a bias uncovered by renowned psychologists Daniel Kahneman and Amos Tversky.
Loss Aversion is a tendency to weigh potential losses greater than an equivalent gain. For example, many people ‘feel’ the pain of a 10% drawdown in their portfolio more than they ‘feel’ the enjoyment of their investments appreciating by the same percentage.
So why is this the case? One theory is that loss aversion relates to evolution. Bryce Hoffman of Forbes explains the concept as follows:
In the natural world, avoiding threats and potential harm is more critical for survival than seeking out new rewards. Early humans who were cautious and avoided dangers were more likely to survive and pass on their genes. Over time, this survival mechanism became ingrained in human psychology, with losses triggering a heightened emotional response to signal caution.
However, in modern contexts, this protective bias can lead to irrational or overly conservative decision making.
Loss Aversion and Investing: How It Shows Up
Loss Aversion manifests itself in different ways for investors. For some, it hits when the market is falling rapidly (think the Global Financial Crisis of 2008, the COVID-19 crash, or the recent tariff-fuelled decline). An investor may see their portfolio shrinking and act to limit the damage by cashing out. At a deeper level, of course, their panic selling is rooted in a desire to stop the psychological pain caused by the market rout.
For others, Loss Aversion isn’t tied to one acute event, but rather a longer-term fear of assets (typically equities) falling in value. These investors often park most of their money in ultra-conservative investments such as Guaranteed Investment Certificates, focusing almost exclusively on preserving capital rather than growing it.
The Cost of Loss Aversion
The behaviours that stem from Loss Aversion—selling stocks when the market is in freefall or not investing in equities in the first place—may feel satisfying. These actions can reinforce an inherent desire for safety, which is a very human need.
But over the long-term, Loss Aversion is paradoxically quite costly. The investor who sells in a panic usually misses out on the eventual rebound. Meanwhile, the person who avoids equities altogether foregoes the capital appreciation that the stock market has historically provided.
The consequences of Loss Aversion are a stark reminder of how crucial it is to stick to your investment plan. Equities can fall (sometimes significantly), but over time they’ve trounced ‘safer’ assets such as GICs.
The lesson? Avoiding risk altogether can be harmful to your wealth.
So, if you feel you might be afflicted by Loss Aversion, consider parting ways with this cognitive bias. Chances are your portfolio will appreciate it.