The fear of loss is a powerful emotion for investors — and, if left unchecked, can cost them big bucks in the long term due to years of forfeiture of investment gains.
That fear is a natural product of human evolution. Our brains are hardwired to detect risks — a useful cognitive tool that helped early humans and their forbears stay alive, if they had to evade predators or determine what foods were safe to eat, for example.
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Fast-forward to the modern era, though, and that ancient threat-detection and loss-prevention mechanism can do us a disservice.
“We didn’t evolve to live in financial markets,” said Dan Egan, vice president of behavioral finance and investing at Betterment. “We evolved to deal with ‘natural threats.'”
For investors, that evolutionary impulse plays out as “loss aversion bias.”
The premise: The pain of an investment loss is twice as strong as the pleasure derived from an equivalent gain. Investors have a bias toward avoiding financial loss.
Nobel laureates Daniel Kahneman and Amos Tversky demonstrated the bias using a coin-toss thought experiment:
“I’m going to toss a coin, and if it’s tails, you lose $10. How much would you have to gain on winning in order for this gamble to be acceptable to you? People want more than $20 before it is acceptable,” Kahneman said of that exercise.
Loss aversion can express itself in perhaps unexpected ways for society at large, too.
Take education, for example: In a 2011 experiment, one group of teachers in Chicago Heights, Illinois, was told they’d receive a year-end bonus linked to student achievement. A second group was given a lump-sum payment at the beginning of the school year and told part of it would be clawed back if students missed performance targets.
The latter “loss” group saw “large and statistically significant gains” in student test scores, while there wasn’t an impact noted in the “gain” group offered a bonus incentive.
Automatic enrollment in 401(k) plans, as well as an automatic increase in a worker’s 401(k) savings rates from year to year, helps combat bias, too. Automatic enrollment means a worker never experiences a decrease (or “loss”) in take-home pay once they start saving in a 401(k), since that savings is deducted from the beginning.
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Nearly all investors have likely confronted fear this year.
The S&P 500 index, a barometer of U.S. stock performance, is down 17% this year. Meanwhile, U.S. bonds, as measured by the Bloomberg U.S. Aggregate bond index, have lost 13% in 2022. If both finished 2022 in the red, it’d be the first time since 1969.
Loss-aversion bias can manipulate investors’ decision-making…