In 1979, Nobel-prize winning psychologists Daniel Kahneman and Amos Tversky highlighted the concept of ‘Loss Aversion’ to the world in their landmark research on Prospect Theory. In simple terms, it means humans prefer to avoid loss rather than make a gain of equivalent value. A global study in 2020 by Columbia University across 19 countries provides an empirical foundation to the Loss Aversion theory.
Loss aversion plays a big role in how we invest – due to fear of losses (rather than excitement over potential gains), you may not invest at all. Or you may exit the market completely when you face a small loss. Overcoming your loss aversion can unlock the path to wealth by letting you invest meaningful amounts of money for long periods of time.
Here are some ways to achieve this
First, don’t react quickly when making a decision about your investments. How to do this? One way is to set up a barrier between yourself and actions in your investments. Having to talk to a designated friend or your spouse every time you take an action may reduce the frequency of your actions. Others have developed a habit of writing down the reason for each action in a notebook – when forced to explain it in writing, sometimes we realise our fears are unfounded.
Second, reduce the frequency of checking your portfolio performance. For example, you should not look at daily performance of your investment portfolio – may be only over the weekend or once a month. Frequent monitoring can amplify fear of losing your money when small moves occur. This phenomenon is called Myopic Loss Aversion – investors who check their investments every quarter are less likely to see a loss (and hence take bad actions) than those who check their investments every day.
Third, get the help of a professional such as a financial advisor or use an app that provides financial guidance. Such a trained professional can help you avoid mistakes and think longer term about your investments.
