The human brain is hardwired to avoid losses. The psychological pain we feel at losing money is about twice as powerful as the pleasure we feel at winning the same amount. Which means we tend to work harder to avoid losses than we work to increase our gains. This is known as loss aversion.
If you are letting loss aversion make your investment decisions, then you are likely hamstringing your own options for investment growth. Here’s how to ensure that rational decisions—and not fear of loss—are prompting your investment choices:
Loss aversion is all about trying to protect yourself from future pain. Unfortunately, this self-protection is often an overreaction to both market losses and surges.
For example, when the market experiences a crash, many investors feel the need to cut their losses for fear of losing even more. As we saw in 2008, many investors watched the housing bubble burst and were afraid that all of their investments would soon be worthless. Fearful investors liquidated their investments—which meant they made a temporary loss a permanent one. Loss aversion made such investors overreact to a market correction.
Investors can also overreact to a market surge by sitting on investments that are growing rapidly. This is another loss averse behavior, since such investors are still afraid of potential losses. If a stock is doubling in value every week, you might fear that you will leave money on the table that could have been yours with just a little more patience and nerve.
You would hate to kick yourself for selling at $12 per share when your stock ends up trading for $70 per share just a month later. But such rapid growth is often an indicator of a bubble, rather than the stocks’ legitimate worth.
The Action Bias
In the face of an ambiguous situation where we might suffer a loss, our universal preference is to act to prevent that loss. This universal human preference is known as the action bias.
Loss aversion can trigger the action bias anytime your investments take a dip, and it can feel almost impossible to sit on your hands if there might be something you could do to improve the situation.
Letting that urge to “do something!” get behind the wheel of your investment strategy is a sure way to overreact, however. Your fear of doing nothing could lead you to sell when the market is at its lowest and buy when it’s at its highest.
Keeping Loss Aversion Out of Your Investment Choices
We tend to overreact to market changes because we have trouble recognizing they are temporary. So, it’s helpful to plan ahead for how you will react to market fluctuation.
For instance, committing to a savvy, long-term, buy-and-hold strategy can help you to remove loss aversion from your investing equation. This is especially true if you invest in dividend stocks, which pay you to hold onto them while you wait.
This strategy helps you avoid overreactions since you will know that you made the best decisions for your money ahead of time, before your emotions got involved.