How do you make money? Forex? Property? Gold? Forget that, let me tell you how it really works: The best way to make money is to not be chickens**t. There, I’ve said it. The sentence that every fund manager, stock broker, and investment banker is too polite to say to your face. Mind you, this doesn’t mean you should ignore potential losses; just that you shouldn’t take loss aversion to an extreme:
Loss Aversion vs. Risk Aversion
Loss aversion is not the same thing as risk aversion (although they’re related).
Simply put, risk aversion is a preference for certainty. Let’s say I offer you a choice: I can give you $200, or we can flip a coin: Heads you get nothing, tails you get $300.
Most of you would opt for the $200. The rest of you fund casinos.
Loss aversion is a lot weirder than risk aversion. It happens when you combine risk aversion with a (contradictory) appetite for risk. It works something like this:
Say I put money into two mutual funds (fund A and fund B). Fund A generates an okay return. Fund B sinks so fast, Celine Dion wants to write a theme song for it.
If I suffer from loss aversion, I might be quick to pull out of fund A, as I want to run with the money I’ve made (risk aversion). But paradoxically I may stay with fund B, in the hopes that it will rise and make up for the losses incurred (risk appetite).
Loss aversion leads to the following problems:
1. You Lose Money for Imaginary Reasons
When you’re loss averse, the pain of losing far exceeds the pleasure of winning. That in itself wouldn’t be a problem (or else Russian roulette would be a regular feature of casinos everywhere).
The problem is that you can imagine potentially losing far easier than you can winning. This is the whole reason people throw money at motivational coaches – many of us are so crap at being optimistic, we even need to pay for help to do it.
And since you keep imagining things going wrong, you do things like buy too much insurance – or refuse to buy even blue chip stocks because “everything related to stocks is dangerous”.
Simply put, loss aversion is a painful paradox: it means accepting absolute losses, in order to avoid potential losses.
How to Get Over It:
Write down the worst possible consequence. How much will you lose if a particular stock crashes, or if you buy that PC and walk away without the extended warranty?
Often, the process of writing – and thinking through – the potential losses is enough to stifle your aversion.
(If after thinking about the loss you still feel there’s too much risk, then follow your instinct. Chances are you’re facing a real concern, and not just loss aversion).
2. It Affects Your Ability to Tell When You’re Being Ripped Off
Lay investors tend to be okay with anything a company does, so long as it doesn’t cause them a loss. Let’s take Investment Linked Insurance (ILPs) as an example.
If an insurer suffers a loss, and then inflicts it on policy holders by lowering bonuses, there’s a hue and cry. You’re all financially savvy, and there’s no way you’ll stand for that.
But what if an insurer’s funds does remarkably well, and they choose not to reward you with higher bonuses? Odds are, you won’t even notice. Or if you did, it’s causing you less psychological pain – so you don’t complain too loudly.
This same effect allows various financial organizations to reassure you with “capital protection guaranteed”. You might effectively lose thousands from a poor investment (e.g. it’s consistently beaten by inflation), but still be tricked into thinking it’s a good deal. They’re just preying on the insecurity caused by loss aversion.
How to Get Over It:
Don’t be a sucker for capital protection. Compare the investment option to others, and see if you can make a lot more money elsewhere.
3. The Sunk Cost Fallacy
As explained above, it’s hard to make yourself give up on a bad decision. When you buy a stock that tanks, a large part of you wants to hold on. After all, you want to at least recoup the cost. And that’s exactly what I thought…
Truth is, even veteran investors sometimes make this mistake. In the interest of avoiding loss, we take risks on the improbable – often the highly improbable. And it doesn’t just happen with stocks.
Consider someone who hires a bad interior designer: His wallpaper cracks, his lighting sometimes won’t work, and the tiling pattern seems to be “wherever they land when we throw them off the truck”. The wise move would be change designers, and cut the old one loose.
And yet this interior design victim might persist, despite the stress. Because the designer has already been paid the first installment, and he doesn’t want to lose that. So he keeps going with the bad designer, in some vain hope that things will change.
How to Get Over It:
As with point 1, write down the probable costs and failures. What would come of holding on to a bad deal?
Next, write down what you’d lose if you let go of the deal.
Checking the difference between the two should kick your frontal lobes in gear.
Are you loss averse? Comment and let us know!
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