What is Loss Aversion?
Loss aversion is a term coined by psychologists Daniel Kahneman and Amos Tversky. It claims the pain we experience from a loss is twice as great as the pleasure from an equivalent gain. This means for someone to accept the risk of losing $10 in a coin flip, they would need the chance to gain $20 for winning.
With this in mind, loss aversion can be a driving force when making investment decisions. All investments, including cash, carry some form of risk you must accept. The difference between them is how quickly that risk can manifest itself.
This can lead many to focus on avoiding short-term volatility while potentially exposing themselves to longer-term risks.
Loss Aversion to Sudden Risks
When people think about “losing money” from investing, they view it as getting into a car accident. Where an unavoidable sudden shock can cause damage that can take years to recover from.
With this in mind, some may want to avoid driving altogether, to ensure they never get into an accident. However, you can see the potential accommodations you would have to make to your lifestyle by never using the motorways again.
Loss Aversion to Gradual Risks
There is another kind of risk that is often overlooked. This is the potential erosion of your purchasing power from inflation. Since this can take years or decades to occur you are less likely to feel it taking place.
This gradual loss is similar to living a sedentary lifestyle. Meaning skipping a single workout is unlikely to have much effect on your long-term health, but years of consistent inactivity can result in serious health consequences later in life.
We tend to be averse to losing and this aversion can frequently manifest itself in our investment decisions as you can see in the examples above there are different risks that are associated when investing.
The sudden risk that can occur in the stock market and the gradual risk that comes from conservative investments. In both instances, careful planning and the development of a strategy can attempt to mitigate these potential risks. This can allow you to tie your investment plan to your goals to ensure your approach is prudent given your circumstances.
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