Asked if they would be less likely to sell an investment if it meant making a loss, 36% of respondents to an eZonomics poll say "yes"; 64% say they wouldn't be less likely to sell. The poll question touches on a behavioural economics principle known as loss aversion, or, put simply, people's tendency to dislike a loss more than they enjoy a gain.
This means that we are particularly reluctant to realise a loss, if it takes us below a pre-determined reference point, even if it may be in our ultimate benefit to do so.
For example, say you have €20,000 in your bank account and lose €10,000. You will have €10,000 left over – but you will feel much worse than if the person who started with nothing and made a gain of €10,000. Both of you have €10,000 – but for one of you the figure represents a big loss. Some say loss aversion often stops investors selling (even when it is financially better to do so) when a deal has not turned out well.
Loss aversion and white picket fences
Loss aversion is seen across a wide range of investments, including property. A new paper on research portal SSRN and outlined on the Finance Professor blog showed homeowners are more willing to sell their property if they can get at least the same price as they paid for it.
But if the property market falls, for example, such a stance might turn out to be increasingly costly. Similarly, motorists might choose to repair to a car (when it may be better to replace it) because they spent a lot of money on the car in the past. Those costs are "sunk" and cannot be reversed, but if your reference point includes those costs then selling that car would mean realising a loss for those past repairs.
Battling loss aversion
There are no certain ways to avoid the problems that can arise from loss aversion. Simply being aware it exists is a good first step. Likewise, it can pay to take the time to think through financial decisions rather than making them in a rush. Loss aversion can affect assessment of risk.
An investment may be advertised as giving an 80% chance of gain, which sounds more attractive than a 20% chance of losing money. Think through percentages and probabilities, as it might reveal a risk you are not prepared to take.