Loss Aversion: What We Can Learn from a Nobel Prize Winner
In 2017 Richard Thaler won the Nobel Prize for his work in behavioral economics. His work spanned many areas of behavioral economics and focused a great deal on biases. Due to recent market volatility, I thought today I’d write about his fascinating work on loss aversion.
So, What Is Loss Aversion?
What is loss aversion?
By definition, loss aversion is the cognitive bias that describes why, we as individuals, feel loss twice as badly as we experience an equal gain. For instance, ever put a $50 bet on something and win? You start thinking, hey that is great I got an extra $50 to mess around with. But, let me ask you this? Have you also put $50 on a bet and loss? You start thinking, darn it that could have bought dinner tonight and you get irrationally mad? That, my friend, is loss aversion.
Now, it is important to note that loss aversion isn’t entirely your fault. You see we are genetically wired to avoid loss, think fight or flight. When we experience loss there are 3 areas of our brain affected.
What areas of the brain does loss aversion impact?
The amygdala (creates fear)
The striatum (deals with prediction errors)
The insula (affects disgust)
Basically, when you put these three things together our brain gets panicked, and thus calculates how to avoid loss, and works together to do everything it can to avoid this feeling. What makes it worse, is that when measuring these three areas of the brain, when experiencing an equal gain, the effect is twice as pronounced in a loss situation.
Financial Planning and Loss Aversion
Now as a financial professional, dealing with thousands of individuals over my lifetime, I’ve had the pleasure to see this play out more times than I’d like to recount. It is why the skill set of identifying and helping coach around this phenomenon is so critical to what a good financial planner brings to the table. As a matter of fact, studies suggest it is one of if not the single biggest factor a financial planner adds to your financial situation.
The Stock Market and Loss Aversion
Why do I bring this up now? During times of turbulent markets, I think it is important to educate and remind our clients of these situations. Let me ask you an honest question, and you can raise your hand privately if you fall victim to it. Let me set the stage. For the past 10 plus years, the stock markets have been on a torrid rise. You’ve had the benefit of watching your money compound and grow substantially. Take 30 seconds for me and think about the feeling you had inside as wealth was created beyond your wildest dreams…… OK, times up! Pretty good feeling, right?
Now, let’s flip the script for a second. In the past 2 months or so the markets have cooled off a bit. Down this year 8-10% give or take. Now, let me ask you the same question. Stop for 30 seconds for me and think about the feeling you’ve had this year seeing the markets, and your accounts down…..OK, times up! Are you panicking yet?
The feeling you likely just had was loss aversion. In real-time, you saw those three areas of your brain go into full effect. You may have said things to yourself like, this time is different, or I can’t afford to lose money now. The brain is a powerful thing, and can really mess with us, to say the least. The inevitable question to be asking is how can one help combat this hardwired reaction?
There are a few things I highly recommend.
- Work with a professional. There is a reason we give ourselves terrible advice and not only in finance. We as individuals have a hard time being truly objective. Ever get dumped, not get that job or promotion, lose a big sporting match, or simply fail at something? If you are like me, you were incredibly and irrationally hard on yourself. Then your coach, therapist, parent, teammate, or friend helped talk you off the ledge. This is what us professionals do when it comes to your finances.
- Frame the situation. Framing is a powerful tool and one I know I use a lot with clients. It is a way to isolate the situation and help people truly put into perspective what they are going through. For instance, if you called me up today panicked about the markets, I would say things like, this time is not different, or remind you this is part of normal market cycles. I can show you graphs, talk statistics, or simply show you we have a strategy that will allow you to weather this storm too. Framing works, and I find it always best done in pairs.
So, how can you combat loss aversion?
Work with a professional, and frame the situation.
Don’t listen to me, listen to Nobel Prize winners
You don’t have to listen to me alone when I tell you all this. But know when I or my colleagues give you advice during good times and bad it is founded on science. We carry a strong superpower with us called experience. You’ve hopefully chosen to work with us due to this experience, and if at all nervous, now is when you should truly listen to the experts you employ and trust. Think of us today as that best friend who told you that you are as good-looking today as you were yesterday before you were dumped.
Most importantly know we are here for you in good times and bad.
As always stay wealthy, healthy, and happy.
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