Nearly 40 years ago, two psychologists, Amos Tversky and Daniel Kahneman, came up with a theory that became one of the founding principles of behavioural finance. Most people, they observed, don’t like losing and they tend to focus more on losses and defeats than they do on goals and victories.
Loss aversion, as this behavioural bias is know is known, applies to several aspects of life, and one of them is investing. In a later study, in 1992, Tversky and Kahneman calculated that investors feel around twice the emotion over a loss than they do over a gain.
There are those who claim that the impact of loss aversion has been exaggerated, and it’s true that some investors have the opposite tendency; in other words, they actively seek risk. It is however generally accepted now that most of us are loss-averse to some extent or other.
The question, then, is how can investors overcome loss aversion, or at least find ways of compensating for it?
In the third video in our six-part series on behavioural finance, Your Own Worst Enemy, we look at what loss aversion is, how it manifests itself, and what can be done about it.
As with all behavioural biases, the solutions seem simple enough in theory, but they’re much harder to implement in practice. Having a financial adviser who really understands you and can provide you with an objective opinion is the best way to manage your behaviour, but we hope this video series provides you with some useful pointers.
Have you seen Parts 1 and 2 of this series? If not, you can catch up with them here. Part 4 will be available at the beginning of November.