We humans are an odd lot, and we have some odd behaviors wired in us that are not always helpful in the realm of personal finance. Loss Aversion is just such a behavior. First documented by Daniel Kahneman and Amos Tversky in their 1979 paper “Prospect Theory: An Analysis of Decisions Under Risk”, Loss Aversion is the tendency to perceive the impact of a loss as greater than an equal gain. Other studies have indicated that losing a sum of money is twice as painful as receiving the same sum is pleasurable. So, losing $100 creates twice as much pain as gaining $100 creates pleasure. That’s why casinos use chips and other proxies for money; they want to reduce the pain of losing. When viewed clearly you can see that the change in net worth is the same, but there is something about possession and loss that wires us to have never wanted to have the asset in the first place. It creates a skewed understanding of portfolio performance. As a financial adviser, I’ve had clients that express very high tolerance levels for risk until a loss appears on the statement, and then they become very unhappy. I try to avoid these clients.

Another part of his psych-out is our tendency to view the most recent short-term performance of a long term investment as more important than the long term performance. That is a fancy way of saying we tend to be short sighted when evaluating performance. We weigh the most recent events more heavily than long-term issues. Even when there is a 30-year time frame we tend to evaluate performance and make decisions on what has occurred in the past year or two. When you combine this tendency with Loss Aversion you get Myopic Loss Aversion, an even more damaging behavior. For example: An investor places $100 in an investment and has great returns. Over the course of five years the money doubles to $200, then the crash and the investment drops 25% to $150 dollars. Even though the average return over the six years was about 7% the typical investor remembers the drop from $200 to $150 most acutely, and emotionally feels cheated even though they experienced a solid return. This emotional reaction occurs even if the investment has outperformed its’ peers. If you want to read more about this track down a study by Shlomo Benartzi and Richard Thaler from 1995, “Myopic Loss Aversion and the Equity Premium Puzzle” (currently available in PDF format here).

If you understand that your emotions, (your “gut” can be your enemy as well as your friend in finance) you are better equipped to make an objective decision about your future. Before you jump to an action, take the time to look at the long-term performance of your investment as well as your actual experience and compare those figures to the average performance of that type of investment. Simply refuse to take a leap until you know where you really stand.

In the next post we will take a look at Hindsight.

Jim Heitman, CPF Jim Heitman, CFP®, is a writer, speaker, Certified Financial Planning practitioner in Southern California, and the founder of Compass Financial Planning – a fee-only planning and money management firm.