Loss aversion theory: What is it and how does it affect your investment decisions?
If the thought of losing money is so painful for you that you pass up opportunities to potentially make money, you’re not alone. In fact, it’s likely not just money that you’re afraid to lose.
Have you even turned down a bet because you were too scared to lose, despite there being a 50% chance you could win? What about when you were young and someone challenged you to a running race, but you were more afraid of the embarrassment of losing than you were motivated by the possibility of winning?
This is called loss aversion theory and it explains our natural instincts to avoid loss wherever possible, even if this means sacrificing a potential gain. It’s estimated that our emotional response to losing something is twice as strong as our emotional response to gaining something.
This is why, instead of the possibility of getting a reward for good driving, we’re threatened with a fine if we break the road rules. We’re much more motivated to avoid getting a fine than we are motivated to drive safely for the sake of getting a reward.
How loss aversion theory impacts your investments
With investing, loss aversion theory is the idea that a $5,000 loss is more painful than the joy of a $10,000 gain. Because we’re naturally wired to avoid losses, a lot of investors are more cautious with their investment approach than they perhaps need to be.
This is where the problem lies. Some investors are so afraid of losing money that they keep their money exclusively in low-risk, low-return products like savings accounts and term deposits. Yes, $50,000 sitting in a savings account for 10 years is much safer than putting that money in the share market, but it will also deliver much lower returns.
How to manage your portfolio to mitigate the risk of loss
Being aware of loss aversion theory gives you a better understanding as to why you’re inclined to make certain investment decisions (or, why you’re inclined to sit on the sidelines and do nothing at all). The key to managing this risk is diversification.
If you invest exclusively in equities and property, your chance of loss is a lot higher (just look at the year that Australian shares just had!). Corporate bonds carry much lower risk than shares. However, for a slight increase in risk, they provide a higher return than a standard term deposit¹. The beauty of having some bonds in your portfolio is that they’re generally not affected by equity market volatility, so if your shares are falling in price you’ll have the bonds to cushion the blow and the loss won’t feel as painful.
Having a healthy mix of bonds and shares means you’re still likely to reap the benefits of capital growth that equities are known to provide, but with a lot less pain along the way.
¹ Term Deposits may enjoy the benefit of protection under the Financial Claims Scheme.
The information in this article is general in nature. It should not be the sole source of information. It does not take into account the investment objectives or circumstances of any particular investor. You should consider, with or without advice from a professional adviser, whether an investment is appropriate to your circumstances. Australian Corporate Bond Company Limited is the Securities Manager of XTBs and will earn fees in connection with an investment in XTBs.