Loss Aversion Theory has been studied extensively in modern investing psychology to try and explain the irrational decision-making tendencies that all investors, new or experienced, are exposed to. The theory states that humans perceive a real or potential monetary loss greater than they will an equivalent gain.
Research studies suggest that the pain associated with losing $100, is greater than the joy we experience in finding the same amount. Some point to the fact that humans have many complex emotions that can get in the way of making rational decisions, especially when their money is concerned.
Emotional Decision Making
Emotions tend to get the better of us when investing our money, which can lead to making poor decisions driven by fear of losing money. It’s natural for investors to feel apprehensive about investing their money in riskier assets for potential of greater gains, especially during times of high-interest rates, where secure short-term fixed income investments have exceptionally high yields. In current market conditions, recency bias of poor performing equity markets may scare some investors away from investing their money in equities due to recent losses.
According to Loss Aversion Theory, investors who experienced recent losses will weigh those losses disproportionately compared to a gain of the same magnitude. This psychological bias can dissuade future investments in riskier investments due to the negative feelings associated with their loss. While the reasoning behind those feelings is valid, it’s important to be aware of the effects of Loss Aversion on your investing decisions. Investors who are aware of psychological biases affecting their investing decisions will be better suited to stick to their goals and make better investing decisions.
Bad News Looms Larger than Good News
When bad news seems to outweigh the good news seen in markets, investors are prone to place more weight on the bad over the good. This can cause widespread panic during recessions, prompting investors to sell their stocks, but then fail to re-invest in the market when things turn around. An important concept in investing is “time in the market” instead of “timing the market”. Staying invested throughout periods of economic slowdown guarantees that you will not miss positive returns when the market rebounds.
Timing the market perfectly to achieve the highest possible returns is difficult due to the volatile nature of short-term market returns. The effects of Loss Aversion can cause investors to sell their quality securities in fear that the stock will continue to go down. In some cases, those investors miss out when the market rebounds, which forces them to invest at a much higher price due to the unpredictability of market fluctuations.
The graphic below illustrates this point by comparing an investor who stayed continuously invested from December 2012 – 2022, opposed to someone who withdrew their investments in fear of losing money. The impact on their investments is substantial if they were to miss the 10 best days of market returns on the rebound. The impact is greater if they were to miss the 20 or 30 best days of positive returns. This graph illustrates the importance of staying true to your goals and not selling your quality investments during periods of negative returns:
Dynamic Volatility Resources
Studies regarding the field of behavioural finance reveal deeper insights into the cognitive reasons humans make investment decisions. It’s one of the most crucial aspects of investing that can often be overlooked, but plays a huge role in investors' decision making. Behavioural finance helps us understand why market bubbles and panics occur. Financial models have adapted in recent years to try and explain these emotions and psychological biases.
Following your investing goals and asset allocation strategy is essential for minimizing the effects of Loss Aversion Theory. Having well-founded objectives for your financial journey can help keep your long-term goals in mind during periods of low return. Remember that individual circumstances vary, and it’s important to consult with your advisor about your personal financial situation. Staying informed on behavioural finance topics is a critical tool for investors to stay confident in achieving their goals and avoiding emotional decision making.
Source: Dynamic Volatility Resources (2023). 5 Timeless Tips on Managing Market Ups and Downs (dynamic.ca)
Investopedia (2022). Loss Aversion: Definition, Risks in Trading, and How to Minimize (investopedia.com)
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This information has been prepared by Mike Holyk who is a Senior Investment Advisor for iA Private Wealth Inc. and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.