What is Loss Aversion?

How to be a Better Investor: Morningstar Investment Management's Dan Kemp discusses loss aversion and why deleting investment apps can help you make better decisions

Holly Black 24 February, 2020 | 11:21AM
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Holly Black: Welcome to the Morningstar Series, "How to be a Better Investor". I'm Holly Black. With me is Dan Kemp from Morningstar Investment Management. Hello.

Dan Kemp: Hello, Holly.

Black: This is second in our, "How to be a Better Investor" series, and we're looking at the fact that people can always do a little bit better and there are some common pitfalls that we all make when investing.

Kemp: That's exactly right. And these common pitfalls are normally driven by the way that we make decisions as human beings. They've been in our makeup a very long time. They're tough to get over.

Black: So, if in doubt, it's not your fault, anyway.

Kemp: Exactly right. It's the creature that we are.

Black: So, what's the second pitfall that we're looking at today?

Kemp: Well, one that I think is so important is something called loss aversion. People sometimes talk about risk aversion. The idea that people don't like taking risks. That's not really true. What people don't like is losing things. We suffer from loss aversion, and you can see that if you ever go into a casino that – I don't go into casinos. But people that do go into casinos can validate this, that when you go in at the start of the night, people tend to spend their chips at the roulette table very carefully, and try and lose money as slowly as possible. But when they get to the end of the night, they just have a few chips left in their pocket, they tend to go for really high risk bets. So, people move from being risk averse at the beginning of the evening when they have lots and then when they've lost that money, they become risk seeking because they're trying to get it back. And we see exactly the same thing in investment.

Black: And this is the idea also that weirdly, we feel it more acutely if we lose £10, we'll feel that loss more than we get excited about winning £10.

Kemp: That's exactly right. So, the idea that's normally stated is that we feel losses twice as keenly as we feel gains. So, we hate losing £10 as much as we like making £20.

Black: So, how does this move into investments? How does this affect what we're doing?

Kemp: Well, it has a whole range of effects. But some of the most common are that as people see a stock falling in price or fund falling in price or their portfolio falling in price, first of all, they feel that they've got to stop losing money. And so that can lead to people selling investments when there's just a small dip in prices. But equally, if you have a real loser on your hand, suddenly, let's say, fallen by 80%, then people are normally very keen to hang on to it. That even if everything is going wrong, they don't want to sell it at that point, because they're hoping it will get back to the value that they started with. And so, something that I find always helpful to remember is that an investment that's fallen by 90% is one that's fallen by 80% and then halved. So, actually, loss aversion can really hurt you, not only when you're taking small losses, but also when you're refusing to take big losses.

Black: Gosh, so this is a case of knowing when to cut your losses and when things genuinely can turn around, although maybe if you're down 90%, not so much.

Kemp: Well, not so much in that – by that point, yes. But you never know that the key thing is that people tend to want to cut those losses early, which is why the upsy-downsiness of the market can cause so many problems for people. But also, often they sell things that are going well, too early, as well. And so, both sides of the coin can hurt people.

Black: So how do we avoid doing this? How do we be a bit more rational about when we're buying and selling?

Kemp: Well, there's been a lot of good work done on this. And one of the things that seems to be most powerful, is just to stop looking at your portfolio. You be a long term investor, the more you look at your portfolio, the more you're likely to be aware of that upsy-downsiness. And the more likely you are to be caught by loss aversion. And so, if you have a good strategy, whether you've worked as an adviser, or you put something together diligently yourself, or you have a portfolio that someone else is running, stop looking at it so frequently,

Black: Well, that was probably easier. You know, 20 years ago when you just got your annual statement for a bit. Now it's online, it's on your phone. People need to just delete the apps.

Kemp: Delete the apps.

Black: Forget your logins.

Kemp: Exactly, right. Yes, you have to review periodically. Of course, you want to make sure that the person is looking after your money or the risk of the funds you invest in is appropriate. But it's much easier to make that assessment over a longer time periods than over short time periods.

Black: Thank you so much for your time.

Kemp: Thank you. It's been great to talk to you

Black: And thanks for joining us.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Holly Black  is Senior Editor, Morningstar.co.uk