Is Loss Aversion Wrecking Your Financial Life?

No one likes to lose money, but the different ways that we psychologically weigh losses and gains might come as a surprise. Behavioral economists use the term “loss aversion” to describe the way that we feel the pain of loss more than we enjoy the pleasure of gain.

Professor Daniel Kahneman (Thinking Fast and Slow), describes in his writings the simple coin toss as an example. Let’s assume that if the coin toss comes up tails, then you pay $10; if the coin toss is heads, you receive $10. Since a coin toss is a 50/50 probability, one might think you would find willing participants in this exercise if heads paid $11 or $12, allowing for the possibility of a small gain. The actual findings, however, show that most players want $20 or more for the heads to compensate for the pain of the $10 loss from tails. This two to one “weighting” of losses to gains is commonplace. People care much more about not losing the $10 than they do about making $10.

Some of you may remember our discussion recently on “anchoring.” Loss aversion is a close cousin to “anchoring” because it unduly influences decisions outside the realm of rationality. One of my early mentors, Harold Gourgues, used to say, “the downside hurts more than the upside helps”. That’s a pretty good summation of how our brains deal with losses…even if the losses are temporary. The key, and the connection to “anchoring” is what we use as the reference point for measuring losses. That is, are we using our original cost, the price last month or the market high to determine our loss?

The way out of the loss aversion trap is to change the reference point back to your goals. This is something that you can control. Without the clarity and context of values and goals, it is difficult to steer clear of behavioral hurdles. Ready for a real conversation?

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