Many readers have probably heard the axiom that investors “loathe losses about twice as much as they enjoy gains.” This notion that losses loom larger than gains is a behavioral finance idea known as “loss aversion,” and it’s been around since 1979 when two economists, Kahneman Tversky, formalized the idea in a paper called Prospect Theory. To give you an idea of just how widely accepted the idea of loss aversion is, Prospect Theory is the most cited paper in all of economics and the third most cited paper in psychology.
Loss aversion is pretty much a permanent fixture in the vernacular of behavioral finance. But should it be?
Maybe not, according to findings in a new paper called “The Loss of Loss Aversion: Will It Loom Larger than Its Gain?”, published in the Journal of Consumer Psychology. One of the key assertions in this paper is that “most writings on loss aversion assume it to be a fundamental and generalizable principle rather than contextual in nature.” In other words, we just assume loss aversion applies to everyone in pretty much all cases, instead of considering that losses sometimes loom larger than gains, but not always.
The new research paper’s authors, Gal & Rucker, do not go so far as to say that the Prospect Theory findings are wrong. Instead, they suggest the need for a more contextualized perspective, sometimes losses and gains have a similar psychological impact, and sometimes gains loom larger than losses. In short, it all depends on the situation.1
Which got us thinking about investment planning. Are there some aspects of an investment plan that are so essential that any losses are far more impactful than potential gains? What about goals that are more “wishful thoughts” than actual needs? In those cases, would losses not feel as bad?
Consider your own retirement plan. Would the threat of losses that caused you to have to work 7 years further into the future loom larger than the potential of gains that helped you remodel your guest bathroom? On the other hand, would the prospect of gains that enabled you to buy the motorhome you’ve always wanted to travel the country in be more exciting than the threat of losses that meant you suffered a 1% portfolio loss that you wouldn’t even feel?
Putting an Investment Plan in Context
In thinking about loss aversion in this “context,” a retirement graphic created by J.P. Morgan came to mind. In it, you can see that J.P. Morgan suggests categorizing your investment objectives by needs (essentials), wants, and legacy. Of course, when planning, you want to make sure that you address each category in order from the bottom-up:
Where the notion of “loss aversion” may ring true is in regards to needs and some wants. If your portfolio suffers losses and your needs are compromised as a result, those losses will probably feel much more painful than the pleasure of any gains that you had previously had. In that sense, investors should think about the effects of loss aversion more acutely when it comes to your needs.
However, when it comes to “wish list” wants and legacy planning, perhaps those items or goals are less critical to your investment plan. In that case, the second home or the goal of paying for your grandchildren’s college education would be incredible if accomplished, but not devastating if not. In these cases, gains have the potential to feel much more enjoyable than losses would feel bad.
Keeping an Eye on Your Investments is Our Job
Behavioral Finance is a relevant field, as it informs us about why we make decisions and feel certain ways about investing. Understanding the various nuances of behavioral finance can help us understand why we make certain investment decisions (both good and bad), and hopefully arm us with the knowledge we need to improve our reactions in the future. For WrapManager, that can mean helping our clients manage the emotional aspects of investing, which can hopefully help reduce errors over time.
Learn more about how WrapManager can be your advocate and your advisor, to help you navigate the challenges of investing and retirement planning. Call one of our Wealth Managers today about your goals at 1-800-541-7774 or start a conversation over email at email@example.com.