If you're too risk averse, it will hamper your attempts to build your wealth.
Marcus Aurelius, the stoic philosopher and real-life Emperor of Rome best known to us from Richard Harris' portrayal in Ridley Scott's Gladiator, said that "…loss is nothing else but change, and change is Nature's delight."
Few of us have the capacity to deal with losses in such a manner and if you regularly invest in shares, bonds, property, antiques or any marketable goods it is a cast iron certainty that at some stage you have suffered a loss.
Many people are deterred from investing in anything other than cash because they fear that they will make a loss. Folk memories of the 1929 crash and the subsequent depression have permeated into the developed world's thinking processes as we saw with governments' response to last October's banking collapse routinely invoking the 1930s as justification for all manner of economic pump-priming.
We all exhibit a response known as 'loss aversion' which frequently distorts our perception of losses when compared to gains. This can cause us to make poor decisions where there is any potential exposure to losses. Recognising loss aversion is a small step in improving your decision making processes.
Losses Are Feared More Than Gains Are Appreciated
If you give a young child a toy to play with what happens if you take the toy away whilst they are still playing with it? The child is no worse off than it was before you introduced the toy, yet the benefit of their having played with the toy is now strongly outweighed by the detriment from no longer having the toy (the child will be making his or her displeasure very clear, as you can well imagine).
In recent years behavioural economists, most notably Daniel Kahneman and Amos Tversky, have drawn attention to the psychological phenomenon known as loss aversion where people sometimes go to great lengths to avoid losses. Humans have the tendency to routinely make sub-optimal decisions in order to minimise the risk of suffering any losses.
Numerous experiments have shown that when most people suffer a loss of £100 their psychological pain can only be offset by a gain of at least £200; merely returning the £100 is insufficient compensation even though they are no worse off.
It turns out that the detriment caused by a loss is almost always more than the equivalent benefit produced by a gain of the same amount and can often be as much as 2.5 times greater. There is strong evidence that the asymmetrical treatment of losses is hardwired into the human psyche, due to the need for food security, which dates back to the time when we lived in hunter-gatherer tribes.
One of the more gut-wrenching things an investor can suffer is to sell something only to shortly afterwards see its price jump dramatically, typically due to a takeover or even mere speculation about a takeover. You never forget the first time this happens to you and your loss aversion response makes it harder for you to sell the next time because of the fear of missing out. As the adage goes, never check the price of an investment that you've sold!
Games And Choices
It's fairly easy to test your loss aversion response by performing a simple thought experiment.
Consider a game where you have two choices:
1) You will receive £1 million, or
2) A fair coin is flipped. If the coin comes up heads you will receive £3 million, but if it comes up tails you will receive nothing.
Which option would you take?
A few years ago I tried a variation on this experiment for a third-year economics project and over 99% of people questioned chose option one. This was no surprise; almost everyone preferred the certain £1 million even though option two was more valuable (a 50% chance of getting £3 million is worth up to £1.5 million). The risk of losing £1 million dominated their decision making, causing them to spurn the higher value option. Some of the more enterprising subjects did however ask if there was a third option to sell their place in the game for a bit more than £1 million!
TV game shows like Deal or No Deal and Who Wants to be a Millionaire routinely show loss aversion at work. The banker in Deal or No Deal pitches his offers to contestants at a lower price than probability theory tells us is fair because the dealer knows that contestants' fear of loss causes them to accept prices which are far lower than the game's current true value. Similarly contestants in Millionaire frequently take the money rather than guess because their fear of coming away with nothing takes precedence over a better value guess.
It turns out that loss aversion is not just limited to financial decision making; it influences which clothes you buy, which television programmes you continue to watch and even which route to take when driving to work.
Learn to recognise loss aversion in all its aspects.
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