But – more than that – people tend to hate losses much more than they take pleasure in making a gain. In other words, a person feels the pain of a loss of €100 more than the pleasure of a gain of €100.
Various studies suggest the pain associated with a financial loss is two to three times the pleasure associated with an equivalent gain. Loss aversion comes when we try to minimise these feelings of loss – even when it doesn’t make financial sense to do so.
This tendency to fear losses can affect how we make decisions about money. Perhaps we are less willing to sell an investment that has fallen in value, as that would mean actually realising the loss. We might feel it is less hurtful to keep it as a loss on paper.
But this can be financially harmful as the price of the investment might keep falling, ultimately increasing the loss.
Loss aversion can come into play for a range of asset classes, including shares and property.
Loss aversion has a noticeable effect in the housing market – a sector that can be steeped in emotion – because evidence suggests people are often unwilling to sell their home for less than they paid for it. This can be vitally important because housing often accounts for a large share of individual wealth and falls in house prices can adversely affect the way people live.
Further, there is evidence that people who bought when house prices were rising (a boom) are less willing to sell when prices fall than those who bought when prices were more stable. Perhaps part of the reason is an attempt to avoid the hurt of losses.
One tip that might help investors put losses into perspective is to take a longer-term view of their finances and of prices in general.
The flow of everyday news tempts us to look at asset prices in short time frames with prices going up and down from day-to-day or month-to-month in a seemingly random pattern. At any time, there may be news to support the view that prices have not fallen as much as previously thought or that prices may soon rise. Such news supports the story we want to hear and can dominate our thinking – an effect known as the availability bias.
Taking a step back and taking the time to look at longer term trends in asset prices might help. Question whether conditions are likely to get worse – and, if so, weigh up whether its better to take a financial hit now in the interests of avoiding a bigger one later on. Doing so might require overcoming instincts driven by loss aversion but it could pay off in the long-term.
Clarity Economics’ lead consultant