If you were offered a guaranteed 5% return on your investment versus a 50/50 chance to earn 15% or nothing, which would you choose? Similarly, would you pursue a $1,000 prize at the risk of incurring a $1,000 penalty? These questions, rooted in behavioural economics, reveal a fundamental aspect of human nature: loss aversion.
Loss aversion refers to our tendency to prefer avoiding losses over acquiring equivalent gains. Essentially, the pain of losing $100 often feels more intense than the pleasure of gaining the same amount.
We all value safety and stability, sometimes at the cost of growth. That’s why people tend to take significant risks to avoid losing what they already have compared to what they would’ve done to acquire those assets in the first place. This psychological trait can significantly impact our financial decision-making, often leading investors to favour overly conservative asset allocations or chase the latest fad at the end of its cycle.
Identify Your Loss Aversion
The first step to solving a problem is admitting you have one.
Our experience shows that most retail investors tend to chase returns but are seldom satisfied. The grass is always greener on the other side if you’re keeping up with the Joneses. In contrast, high-net-worth investors focus on not losing money, generating yield (through dividends and interest), and capital gains — in that order. They prioritize diversification and consider risk management as important as the rate of return. These investors know they have a financial problem or opportunity, want a comprehensive solution, and have realistic, long-term expectations. They are not comparing the growth of their wealth to what the hottest index did last month.
The unfortunate reality is that it’s never been easier to check your portfolio at the swipe of a phone. However, checking in too often can have some serious negative drawbacks. The stock market is volatile — it can fluctuate dramatically daily. The more you check your portfolio, the more susceptible you are to the mood of the market, potentially distracting you from your long-term goals.
Research suggests the emotional impact of a loss is about twice as powerful as a gain. This explains why we're likely to feel anxious when our investments dip, but experience comparatively less relief when they rise. The chart below perfectly illustrates the emotional rollercoaster of investing.
The Cycle of Market Emotions
Time in the Market Is Better Than Timing the Market
True to the investing 101 adage, the most reliable strategy is long-term. Make good investments (it’s what you pay!) and hold them for five years or longer. Of course, nobody likes seeing a red-sloping chart, even if it's just a temporary loss on investments. For your mental well-being, resist the urge to constantly check your portfolio. After all, how often do you assess your house's value over a decade?
A 1997 study found that “investors who looked at their portfolio the most frequent[ly] earned the least money." As a general guideline, consider reviewing your investments every one to six months. This keeps you informed without inducing unnecessary worry or impulsive, knee-jerk decisions. Some investors go with once per quarter as a happy medium; it depends on your preferences.
BOTTOM LINE
Loss aversion is a natural, intrinsic part of being human. The key is to take calculated risks aligned with your long-term objectives. Set clear financial goals and maintain a well-diversified portfolio, sticking to the plan when the market hits the fan. If you have any questions or comments, please don’t hesitate to contact us.