Aug 17, 2016
Personal Investor: Do you suffer from loss aversion syndrome?
By Dale Jackson
Imagine this: You’re heading for a nice day at the beach and you find a $20 bill in the parking lot. You stuff it in your shoe and when you come back from swimming it’s been stolen.
You might think it’s a case of easy come, easy go – but a new study from Sun Life Financial finds the pain of losing money is much stronger than the pleasure from gaining it.
It’s a behavioural bias called loss aversion and it helps explain what goes through the minds of the typical investor. The study attempts to quantify it in terms of dollars by asking people how much they would need to gain in relation to the amount they would risk losing. It found most respondents would not risk losing $100 if the potential gain was only $100. More agreed to take the risk as the potential gain increased. It found most investors would only risk the $100 if the potential gain was doubled.
While loss aversion may seem prudent on the surface, Sun Life says it could lead to missing out on lucrative growth opportunities and hurt an investor’s long term financial goals. It’s a fact of investing that the biggest gains most often require the biggest risks.
The study says loss aversion can also lead to decisions based on emotion and not reason. One example is selling a stock after it declines in value in a broader market sell-off. The emotional sting of a paper loss might prompt an investor to sell to end the pain, and make the loss real. Reason would tell you that a stock trading at a discount to the original purchase price is more likely to go up, making a more compelling argument for hanging on or buying more.
Sun Life says the solution lies in understanding the risks in any investment and managing that risk. Risk hedges come in many forms but the most basic is diversification – not just through stocks and bonds, and sectors and geographic regions – but risk itself. Risk diversification means extreme safety at one end of a portfolio, and riskier ventures at the other end. If the risky venture goes bust, the portfolio will be propped up by the less risky investments.
Risk diversification also buys the investor time to make up for a loss at the risky end of the portfolio while the safer end of the portfolio generates gains and income if necessary.
Dale Jackson is BNN's Personal Investor. Follow him on Twitter @DaleJacksonPI
