When Loss Aversion Becomes a Self-Fulfilling Prophecy

When Loss Aversion Becomes a Self-Fulfilling Prophecy

The fear of losing, known as “loss aversion,” trumps the joy of winning in most situations, and this imbalance frequently causes people to make poor choices. Going for the least-chance-of-defeat decision may at first glance seem wise, but this strategy certainly won’t make you a winner.

Professor Kahneman’s definition of loss aversion

Professor Daniel Kahneman won the Nobel Prize (Economics, 2002) for his ground-breaking work in behavioral finance by describing the phenomenon of loss aversion. Giving the illustration of flipping a coin, he discussed the question of how much test subjects would want to win if losing meant that they’d have to pay $20. “For most people,” he said, “when you have a bet with a 50% chance of losing $20, you want to have an equal chance of gaining $40.”

Kahneman uncovered an astonishing psychological barrier that stops people from advancing. Since the average coin flippers stipulated that in order to agree to play the game, their potential winnings had to equal twice their possible losses, imagine how this stunted their potential to ever get ahead. In theory, a flipper should rejoice if he wins, for example, $21 when he only has to put $20 at risk. Illogically, though, he won’t place the bet unless he has the chance to secure a $40 pot.

The disproportionate way in which people regard winning versus losing helps to explain why investors often make decisions based on one of two emotions. According to traditional wisdom, either fear or greed causes people to make an investment move. The flipping study shows that fear motivates people about twice as much as greed does.

What happens when investors’ dread significantly outweighs their avarice? They tend to panic when the market drops and they sell. Maybe they started in stocks as long-term investors who thought they could stomach volatility. But when some bad news flashed across their screens, such as the S&L bailouts, Black Monday, the Gulf Wars, the presidential impeachment, the Russian bond default, the dotcom crises, the terror attacks on the Twin Towers and the Pentagon, the real estate collapse, the banking meltdown, the Japanese nuclear reactor explosions, the European debt crisis, and more, they sold. They suffered from loss aversion, bailing out when economic darkness prevailed.

Take a step back and ask yourself if you suffer from loss aversion. To learn more about the effects of fear on your investment decisions, click here.