By nature, humans love winning money. But there’s one thing we love even more: not losing it.
This phenomenon, known as loss aversion, can be a recipe for disaster when making financial decisions — especially during market downturns. It can cause us to sell stocks and assets at the worst possible time. It can cause us to miss market opportunities. Worse yet, it can cause us to act in opposition to our long-term goals and strategies.
But do we all exhibit loss aversion? Or, are some of us better able to overcome the bias than others? New research published in the Journal of Consumer Psychology by Kellen Mrkva and Eric Johnson of Columbia University found that, while the vast majority of Americans are loss averse, certain types of people are more loss averse than others. Discussed below are some common traits seen in people at opposite ends of the loss aversion spectrum and tips on how to overcome the cognitive error.
What is Loss Aversion?
Imagine that you were offered the following gamble: a 50% chance of winning $6 and a 50% chance of losing $5. Would you play? If you are like most people, you probably wouldn’t, even though the odds are in your favor. Why not? Well, it would likely feel worse to lose $5 dollars than it would feel good to win $6. This is the crux of loss aversion. Indeed, some studies have found losses to be twice as psychologically powerful as gains.
Characteristics of Loss Averse People
Perhaps not surprisingly, people with more experience in financial decision making contexts — think investment bankers, traders, accountants, business administrators, etc. — are less prone to loss aversion than others. In couples, the partner who manages household finances and investments tends to be less loss averse, regardless of gender.
Surveys have also found that Americans with higher income and wealth are a bit less loss averse than poor Americans, but even millionaires are loss averse. When offered an investment with a 50% chance of winning $100 and a 50% chance of losing $50, just 22% of millionaires accepted the bet even though a $50 loss is trivial for millionaires. Less financially well-off Americans took the bet only a little less often, 19% of the time.
Furthermore, people with a high degree of domain-specific knowledge tend to be less loss averse within that domain. In one study, researchers surveyed European car buyers after they purchased a car. Car buyers who had more knowledge about cars were more willing to part with premium features to get a better deal.
Finally, older people tend to be more loss averse than younger people. Perhaps this explains why they prefer penny slots over higher-stakes but better-odds gambles and why they are, at times, reluctant to throw anything away, to the point of exhibiting hoarding behavior. Older people are also more likely to avoid bets that have larger benefits than costs than younger people, according to four studies that each surveyed over 4,000 Americans.
Becoming Less Loss Averse
If you want to be less loss averse, there is hope — even if you are older and less financially knowledgeable. One way of reducing loss aversion is to think about the decision from a long-term perspective. People are more willing to buy stocks and make investments when thinking about the long-term, rather than only thinking about whether the investment will win or lose money today. Or, instead of thinking only about the single possession or investment you are reluctant to sell today, consider that other similar opportunities will arise in the future.
Furthermore, if you find yourself reluctant to sell or throw away your possessions, putting yourself in the shoes of someone who does not own the possession can also help. Consider asking yourself, “Would my friend or neighbor recommend I keep this, sell it, or throw it away?” This form of perspective-taking can make it easier to part with non-essential possessions.
With stocks and investing, it’s always a good idea to rely on financial advisers to protect you from in-the-moment decisions, like liquidating everything in response to the growing Coronavirus threat.
Conclusion. As the stock market continues a wild run, the losses often loom larger and attract more headlines and media attention than equally large gains. Yet it is important to notice the gains in our lives and savor them, rather than being influenced only by the losses.