Did you know that the average person hates losing roughly twice as much as they get satisfaction from making the same or equivalent amount of a gain? A well-known experiment carried out by Kahneman and Tversky involved asking people if they would accept a bet based on the flip of a coin. If the coin turned up heads, they would win €200 but if it came up tails, they would lose €100. The results showed that on average people needed to gain between 1.5 and 2.5 times as much as they were prepared to lose in order for them to proceed with the bet. In the financial world, this is known as “loss aversion”.
A reluctance to give up on something which we already hold simply because we do not want to incur any losses, means we could well be throwing good money after bad. To clarify, if we’re looking at an investment and it was a poor investment to begin with, it’s hardly likely to change unless you do something about it. This plays out amongst so many investors who tend to sell winning portfolios or investments instead of losing ones for the principal reason of not wanting to realise a loss. A reluctance to realise this loss could mean that we are turning down much more interesting, cost-effective or tax-rewarding investment opportunities. Putting it simply, we hate losing or crystallising our losses regardless of how bad that investment may be.
Perhaps one of the most succinct examples of this loss aversion theory can be seen in bookies and casino halls the world over. In this scenario, gamblers virtually always follow the same pattern: They first play to win, and if they do, continue to gamble because it’s now the “House Money” they’re playing with. However, after the inevitable downturn in their fortunes, they typically play to recoup their losses, usually to their detriment.
In marketing and advertising, ploys such as “Trial Periods” and rebates are used to take advantage of the buyer’s tendency to value what they now have more than they would otherwise have done. Whether a transaction is framed as a loss or as a gain is very important to a person’s calculation. For example, would you rather get a €10 discount, or pay a €10 surcharge? The effect of loss aversion in a marketing setting has been demonstrated in numerous studies around consumer reaction to price changes. Studies have found that price increases had roughly twice the effect on customer switching, compared to price decreases.
The question I have posed for years to enquiries around poor investments is simply this! “If your alter ego had an amount in cash equivalent to the current value of this poor investment you previously made, would you invest in this same poor investment today, or consider other alternatives?” If the answer is no, you wouldn’t invest again, then you’ve already answered your own question and should consider withdrawing your funds to look at more appropriate or possibly lower risk or better positioned tax-efficient investments. This will at the very least lower your anxiety and reduce your blood pressure.
Why is having an understanding of this loss aversion heuristic relevant to you? Because, simply knowing that this bias exists in the first place could serve you well in your future decisions and caution you to at least consider, or look a little deeper. The previously mentioned guru of behavioural economic thinking, and noble prize winner Mr Danial Kahneman warned of the “emotion of regret” saying that clients will “feel the pain acutely” of lost investment opportunities and will then, regrettably, seek to act on that regret. He suggests that’s why so many investors, will seek to buy an investment AFTER it’s had its run.
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Paul is the Managing Director of Lifestyle Financial Planners Ltd, has been in business since 1985 and offers specialist, tax efficient wealth management, retirement and estate planning solutions to our customers. Paul is a Certified Financial Planner and holds a Masters Degree from UCD in Financial Services and Risk Management.
Tel; 096-75951 Mob; 086-8053755, Email; firstname.lastname@example.org web; www.lifestylefinancialplanners.ie
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Waiver; The information contained in this article is for general information only and cannot be relied upon as the basis for any form of agreement or advice. The author recommends that you seek independent tax, legal or financial advice relevant to your own particular circumstances.
Posted May 2nd,2017