People hate losing money, and that sometimes causes them to lose more.
If you’re like most people, the mind games in your head are likely leading to poor decisions, causing you to take excessive risks and lose money in certain situations where you don’t have to lose it if you can outsmart your brain.
This is a foundational principle of behavioral finance: The study of how our emotions and cognitive biases (unconscious biases that affect our judgment and ability to form decisions) negatively influence our financial decisions.
One of the most important behavioral finance concepts to understand is prospect theory, also known as loss aversion theory, which is the theory that people care more about losses than gains.
Prospect Theory & Loss Aversion
They revealed a cognitive bias known as loss aversion, where people feel the pain of losses 2.5x greater than they feel the joy of gains.
Kahneman and Tversky’s research also showed that people make inconsistent decisions depending upon whether they’re in a position of gain or loss.
The way the study worked was simple: They presented subjects with two scenarios.
Scenario 1: Guaranteed Money or More (Almost) Guaranteed Money
In the first scenario, subjects were given the option of receiving one of the following:
- $900, or
- A 90% chance of receiving $1,000 and a 10% chance of receiving nothing.
While the probability-weighted, expected return of both choices is $900, subjects overwhelmingly selected (A), the sure thing.
Scenario 2: A Guaranteed Loss or a Chance to Lose Nothing
In the second scenario, subjects were faced with the prospect of losing:
- $900, or
- A 90% chance of losing $1,000 and a 10% chance of losing nothing.
In this scenario, the probability-weighted, expected loss of both choices is $900. Even so, subjects overwhelmingly selected (B), the gamble.
In other words, people avoid risk (risk aversion) when they’re in a position of gains, and are risk-seeking when in a losing position.
Another related principle is the disposition effect: investors are likely to sell winning stocks too early and hold onto losing stocks too long.
The Disposition Effect: Have You Ever Done This?
Imagine you need $30,000 to replace the leaking roof on your house.
You made two investments eighteen months ago; which one would you sell?
| A | B | |
| Original Investment | $25,000 | $35,000 |
| Investment Performance | + $ 5,000 | ( $5,000) |
| Current Value | $30,000 | $30,000 |
Because you hate losses and don’t want to admit a poor decision, your brain will likely convince you to sell investment A and hang on to investment B until you break even.
If this were your decision, you’ve succumbed to the cognitive bias known as the disposition effect: the tendency for people to sell their winners too early and continue holding onto their losers.
Victims of the disposition effect are gambling (on a losing position) against decades of market history that suggests winners are likely to experience more gains and losers will keep losing.
Thus, their emotions and their brain are causing them to trade potential future gains for the likelihood of additional losses.
Retrain Your Brain and Avoid These Cognitive Biases (Or Hire a Financial Advisor to Help)
Savvy investors realize the significant difference in these choices (along with other factors that make selling the winning investment an even worse idea).
For example, U.S. tax policy rewards those who avoid the disposition effect by assessing (typically) lower tax rates on long-term capital gains and allowing capital losses to be written off against other income.
While you may be able to overcome the negative effects of Prospect Theory, most people will struggle with this. It’s simply part of being human.
That’s one of the many reasons a financial advisor can be so beneficial: You have an unbiased third party in your corner whose job is to help you avoid potentially detrimental financial decisions.
Selecting a financial advisor who understands behavioral finance and the potential negative impacts of cognitive and emotional biases is an intangible benefit that could lead to smarter investment decisions.
If you’ve fallen into these traps before, we can help. Schedule a free introductory call today to discuss your financial situation, your goals, and the kind of help you need.