How to Win by Avoiding Loss Aversion
We all want to be happy with our decisions in life. But sometimes we’ll make bad decisions, it’s just part of being human.
As our life experience grows, our decisions generally become better because they’re based on past successes and failures, commonly known as our “gut”. But for many of us, that fear of getting it wrong next time stays with us forever.
With investment decisions, this fear of failure goes beyond just a dent in our pride but we have to deal with the hard-hitting consequences of eventual financial loss, along with all the time, energy and even excitement we may have felt at the very start.
When considering a new investment, we probably put a great deal of thought into that deal. This process is bought with Time and Mind (primarily emotional) Capital:
- Time Capital – the time invested in researching an investment that could have been put to other uses. Includes time spent on understanding the investment proposition; studying the provided due diligence (if any); estimating the risk/reward ratio (on your own or with an adviser or introducer).
- Mind Capital – the personal energy you’ve invested – including the building of personal interest, the sense of “moving forward”, excitement of a profitable outcome and so on. Only the most hardened, analytical seasoned investor is immune to this.
Being mindful of how loss aversion can distort our decision-making is the biggest step towards avoiding it. Rather than labour the definition of loss aversion, here are two examples where it shows up: one before and the after investing. Both scenarios face head-on the challenge of cutting one’s losses.
Loss Aversion Before Investing: I've made up my mind
At this point in your investment research journey, you’ve yet to make that final decision but you have already invested these resources of time and mind. Let’s say that you’re now satisfied enough to being inclined to make the investment, how would you react to being told “hmmm, actually, there may be a problem with your investment”?
- Would you be delighted and immediately welcome this news with open arms?
- Would you pause and reconsider carefully over time (resisting the urge to be hurried into this investment)?
- Or would you be annoyed? find yourself biassed against this “doom mongering” news, skeptically resist this, since walking away from the deal at the eleventh hour would feel like all that valuable energy wasted.
By now, you’ll see that the last of these is a form of Loss Aversion – not of your monetary investment, but of your own personal investment of time and mental energy. Surprisingly many investors would experience this loss aversion and excuse away these new findings.
Most highly experienced investors would recognise loss aversion, see it for what it is. Cutting losses of time and energy would be a far better price to pay than the potential financial loss of one’s capital, which could be substantial.
Loss Aversion After Investing: It's Not Real
What do you do if you were Ben?
Even if the most logical thing to do may be to cut your losses and lick your wounds, many will keep the shares, telling themselves that what goes down must come back up.
But in most cases, it’s Loss Aversion preventing Ben from selling up and crystallising his loss. Up until then, the loss is purely a paper one and doesn’t appear “real”. Even the word “Crystallised” (a paper loss turned into a real loss) sounding so final, fuels the fire of Loss Aversion. Human psychology at work again!
The more personal energy (Time and Mind Capital) Ben spent researching the investment at the start, the more acutely the idea of loss aversion is likely to hit. Add to this being seen to lose face, especially if he invested with others, or simply recommended it to other investors (as fund managers and advisers do all the time), then all the more reason to resist calling it a day – even if it’s the logical next step.
Ben’s example an easy one because he could sell his shares whenever he wanted. Not quite so easy with an illiquid investment such as property or a bond, but the dangers of acting in haste are still there waiting.
How to Tackle Loss Aversion
Being aware of loss aversion as factor in your decision-making is the most significant factor in recognising and dealing with it if and when it rears its head. But being able to make quicker decisions sooner without any loss of decision quality is also hugely helpful. Prevention is better than cure.
Starting at the beginning, the sooner you have all the investment details to hand (and as much as possible from objective, reliable, third-party sources), the less personal Time and Mind Capital needs to be invested by you. If the investment is a poor fit for you, you’ll know more quickly, get it out of your head and be free to move on to the next.
Quick and independent expert research has a triple benefit:
- It’s early in the process – you’ve not invested so heavily in Time and Mind Capital at this point, so loss aversion is less of a problem. There’s less to lose by not going ahead, if that’s the right decision for you.
- By getting due diligence quickly, you’ve saved precious time and energy you could otherwise use on the people & things in your life.
- You have the satisfaction and peace of mind of knowing that all the relevant due diligence “stones” have been turned for you – perhaps including a few stones that you’d not realised even existed.
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