Fear of Losing Money Leads to Very Bad Decisions
How to overcome "loss aversion"
“I hate to lose more than I like to win.”
-Larry Bird
Welcome to another installment in my ongoing series called “Money On My Mind,” where I publish articles to help you deal with the psychological aspects of managing money. Check out past editions of the series here.
We continue our exploration of cognitive biases by looking at loss aversion.
Continue reading to learn:
What loss aversion is
How it prevents you from taking financial risks
The unexpected ways loss aversion can destroy an investment portfolio
How to overcome loss aversion and embrace a healthy view of financial risk
What is loss aversion?
Loss aversion is the term used to describe the fact that most people hate to lose more than they love to win. This is especially true when it comes to money. If you were given a $100 speeding ticket, it would probably ruin your day, even if you could easily afford it. On the flip side, if your boss told you they were giving you a $100 bonus, I doubt you’d be jumping for joy.
That’s loss aversion.
Like seemingly every other cognitive bias we know about, the term “loss aversion” was brought into the mainstream consciousness by Kahneman & Tversky, who describe the phenomenon as “losses loom larger than gains.”1
There is evidence that when the stakes are large, and the outcome is publicly visible, the impacts of loss aversion get magnified.
A 2021 paper analyzed the results of 68,000 games in the NBA and 69,000 basketball games in the NCAA to learn how basketball teams perform when they are losing by 1-4 points at halftime.2 This is a situation where the pressure increases, but the game is very close. The researchers found clear evidence that NBA teams playing in their home arena win more games than expected when they trail by 1-4 points at halftime.
Professional basketball players (NBA, not NCAA) who are trailing in front of their home crowd tend to outperform expectations.
Why?
Because they don’t want to be seen losing on their home court in front of fans who paid a lot of money to see them play, it’s embarrassing.
Being motivated to avoid the pain of losing might be useful for professional basketball players, but it leads to self-sabotage in our financial lives.
Loss aversion makes investors paranoid
Here’s an excerpt from my book “The Rational Investor, where I wrote about the impact loss aversion has on investors.
A 1997 paper written by Richard Thaler discussed how myopic loss aversion impacts investors. They define myopic loss aversion as “greater sensitivity to losses than gains and a tendency to evaluate outcomes frequently.”
They point to two behavioral traps that investors fall victim to.
Loss aversion. People hate losing more than they like winning.
Mental accounting. The narrow framing of current decisions and past outcomes leads to short-term rather than long-term thinking and constant evaluation of gains and losses.
Combine loss aversion with narrow mental accounting, and you get a myopic investor; someone who will constantly check their portfolio and feel deep pain when their portfolio is down.
Given the volatility in the stock market, the more you check your portfolio, the more often you will see your portfolio having a bad day. Of course, the number of good days will outnumber the bad days over the long run, but the myopic investor tends to forget the good days and hold onto the bad days.
Investors are more willing to take on risk if they check their portfolios less often. Put another way, myopic investors who constantly check in on their portfolios take on less investment risk, have lower exposure to the risk premium provided by stocks, and make less money.
No matter what we tell ourselves, we are all, to some degree, myopic investors. The sooner we accept that fact, the sooner we can address the problem.
It’s never been easier to slip into the bad habits of the myopic investor for two reasons.
We have a constant barrage of information about what’s happening in financial markets from 24-hour cable news and social media.
It’s never been easier to access and make changes to your portfolio. Just pull out your phone, and within a few seconds, you can make a potentially devastating financial decision.
Loss aversion is used to sell insurance
I just conducted a fun experiment. I went to YouTube, typed in “home insurance ad,” and this was the first result.
A woman, stressed out of her mind, walks through her living room which has ankle-deep water caused by a leaky roof. She realizes that all her possessions have been destroyed as she tips over her guitar to empty it of water.
That’s how insurance companies use loss aversion to make money. They want you to imagine how painful it would be to lose something you have. Whether it be your house, your pet, your health, or your ability to go to work—insurance companies position their policies as the solution.
Wouldn’t it be awful if your house burned down? Buy house insurance.
What would you do if you became disabled and couldn’t work? Buy disability insurance.
If the family dog got sick, would you let him die because you couldn’t afford the treatment? Buy pet insurance.
The insurance industry is powered by loss aversion.
Just because insurance companies are taking advantage of how much you hate losing doesn't mean you don’t need what they are selling. Life insurance, home insurance, and car insurance are important in managing financial risks.
The extended warranty market is where companies weaponize loss aversion to sell you a product you probably don’t need. A 2018 study of the extended warranty market found that extended warranties are a cash cow for businesses.3 The main reason businesses can sell you expensive extended warranties on products is that people overestimate the likelihood of their product breaking.
When you buy an extended warranty, you are buying an insurance policy with a very small likelihood of paying out, and when it does, the payouts tend to be small.
That sounds like a pretty crappy deal.
Why would anyone sign up for an extended warranty? A 2015 study concluded that loss aversion causes us to opt-in for extended warranties. The researchers gave participants $2 and randomly assigned them one of two incentives for completing a health assessment.
Insurance against a 1% chance of losing the $2, or;
A fixed payment equal to the expected value of the insurance, which is 2 cents (1% of $2)
Participants in the insurance scheme were 70% more likely to complete the health assessment. Giving someone 2 cents was not enough to get them to comply, but telling them they have a 1% chance of losing $2 was a powerful incentive. The thought of losing—even when the odds and stakes are low— has a powerful influence on getting people to take action.
Insurance makes sense for big risks like your health or your house—but extended warranties are typically a ripoff that preys on your deep-rooted hatred of losing anything.
Loss aversion and lifestyle inflation
My first book, “The Financial Freedom Equation,” discusses the slippery slope of lifestyle inflation—when your spending rises just as fast as your income.
If you buy a house, a new car, or take a luxury vacation every time you get a raise at work, you’re a victim of lifestyle inflation. The effects are subtle at first, but they can destroy your finances over time.
Constantly increasing your lifestyle means saving less money.
This isn’t a problem as long as you can maintain your income. But, the minute those big paydays stop coming in is a day of financial reckoning; the income has dried up, and you have little saved and no means of maintaining your expensive lifestyle.
So, you are forced to give up some of the luxuries you’ve grown accustomed to. Once you grow accustomed to living in a bigger house or driving an expensive car, losing those things is painful. This is another form of loss aversion; not wanting to give up the luxuries you enjoy today, even if you can’t afford them.
Overcoming Loss aversion
The better you can withstand financial loss; the less likely loss aversion is to impact how you manage your money.
A 2010 study found that powerful and wealthy people are much less likely to be impacted by loss aversion.4 Why? Because their wealth and connections allow them to take a financial loss without materially impacting their day-to-day lives. If your wealth and power get out of control, it can lead to an unhinged level of risk-taking, like Elon Musk paying $44 billion for Twitter.
If risk tolerance ranges from sticking all your money under your mattress or buying an unprofitable social media app for $44 billion, you want to be somewhere between these two extremes.
The further you move along your wealth-building journey, the less likely your financial decisions will be guided by fear. If you haven’t already, I’d recommend you read this article where I break the wealth-building process into a simple, 4-step process.
Another way to keep loss aversion in check is to stop and ask yourself three questions.
What’s the worst that could happen?
What are the odds of that thing happening?
Would your life be dramatically worse if that thing happened?
If you’re buying a $1,200 laptop and the salesperson asks if you want to pay $200 for an extended warranty, stop and think, what are the odds that I break my laptop and use this extended warranty? How badly would my life be impacted if my laptop broke in a year and I didn’t have the extended warranty?
Odds are you’re better off keeping your $200.
Finally, try and get out of your head.
When people make financial mistakes, they replay that mistake in their heads on an endless loop. Psychologists refer to this as “rumination.”
As bad as it is to obsess over past mistakes, it’s even worse to obsess over mistakes that may never come to pass. When some people take financial risks, they automatically assume the worst-case scenario will happen and preemptively imagine that scenario playing out in their heads over and over.
Few things are less productive than assuming the worst and having that live inside your head. I am reminded of a great quote from an otherwise “blah” movie.
"My philosophy is that worrying means you suffer twice. "
— Newt Scamander in 'Fantastic Beasts and Where to Find Them.'
If you haven’t already, you’ll want to read this post, where I detailed how to build financial resiliency, focusing on how to stop ruminating about financial decisions.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.
Tversky, A., & Kahneman, D. (19withstand losses easierct theory: Cumulative representation of uncertainty. Journal of Risk and Uncertainty, 5(4), 297–323. https://doi.org/10.1007/bf00122574
Easton, S., & Pinder, S. (2021). Loss aversion and high stakes. Accounting & Finance. https://doi.org/10.1111/acfi.12802
Abito, J. M., & Salant, Y. (2018). The Effect of Product Misperception on Economic Outcomes: Evidence from the Extended Warranty Market. The Review of Economic Studies, 86(6), 2285–2318. https://doi.org/10.1093/restud/rdy045
Inesi, M. E. (2010). Power and loss aversion. Organizational Behavior and Human Decision Processes, 112(1), 58–69. https://doi.org/10.1016/j.obhdp.2010.01.001
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.