What is loss aversion?

Loss aversion is a common behavioral bias. Research suggests that the pain of losing is twice as powerful as the pleasure of gaining. The chart below shows that the feeling for losing 100 dollars/pounds is twice as strong as gaining 100 dollars/pounds. In behavioral finance, this is also known as the Prospect Theory.

The market turmoil during the COVID-19 is a perfect example. When S&P 500 lost 30% in early 2020, the fear and pain was extremely strong. But the level of joy when S&P 500 gained 30% in 2019 was nowhere nearly as strong, nor when the market recovered strongly later in 2020.

A common trait shared by amateurs and professional investors, it is deeply rooted in our survival instinct. While gaining is nice, losing food etc. can threaten the survival of an animal.

In fact, rogue traders are more often the result of loss aversion than evil. It often starts with a small loss, and in an effort to cover it up, the trader would double down and take more risk, digging a bigger and bigger hole for themselves.

Loss aversion assessment

Loss aversion can be assessed using this mini questionnaire, which is adapted from the research literature. It has only two questions:

Q1: Out of the two options below, which one do you prefer?
A. 100% chance of gaining $2000.
B. 75% chance of gaining $4000; 25% chance of gaining nothing.

Q2: You are then presented with another set of two options below. Which one do you prefer?
A. 100% chance of losing $2000.
B. 50% chance of losing $5000; 50% chance of losing nothing.

For the first question, a rational investor would choose B, because the expected gain in B is $3000, much higher than the gain in A, while the risk is relatively small. If an investor chooses A, it indicates the tendency to secure gain, a form of loss aversion, because they can’t bear the pain of the 20% chance of getting nothing.

The second question is even more painful to decide. People’s gut reaction is often, “I want neither.” But sometimes we do face a decision like this. For example, a gambler has lost $2000. Would he accept the loss, or doubling down in an effort to win it back? This is how gamblers end up digging a deeper hole for themselves. Rogue traders, who lose hundreds of millions of dollars for their firm, often started out with a much smaller loss, but instead of accepting the loss, they would double down, and dig a deeper and deeper hole for themselves. Doubling down is another form of loss aversion.

The table below summarizes the mapping:

Answer to question 1 Answer to question 2 Has loss aversion?
A B Yes
B A No
A A Some (Secure gain)
B B Some (Double down)

How to use loss aversion assessment?

Loss aversion is a common behavioral bias, and most people have it. Make sure you tell clients that, and that you have it too if you follow your heart (if this is true), so they don’t feel bad. The point is to have this awareness, that the level of panic is not an accurate reflection of the reality, and they can cut it by half.

This is most powerful when you combine the conversation on loss aversion with deep analytics to show the risk and return of the short, medium, and long term of their portfolios.

Since the Risk Tolerance Plus flow is the first priority, we recommend you give the loss aversion questionnaire to your client at the next opportunity.

Having this awareness helps clients put their emotions in perspective. Knowing that the emotion is not an accurate gauge of the reality helps to prevent irrational investment decisions.

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