When people make financial decisions, they are not as rational as one might think. The tendency of people to avoid losses is somewhat ironically considered a recipe for disastrous financial decisions in the current Forbes article. Especially in times of market downturn, the aversion to losses can lead us to sell stocks and assets at the worst possible time. It can cause us to miss market opportunities. Worse, it can cause us to act contrary to our long-term goals and strategies.
Would you play? Imagine…
…they’d offer you a 50% chance of winning $6 and a 50% chance of losing $5. Would you play? If you were like most people, you probably wouldn’t play, even though the odds were in your favor. Why not? The phenomenon that works here is our natural aversion to possible losses. It would probably feel worse losing $5 than winning $6. In fact, some studies have found that, psychologically, losses are twice as painful as gains.
The Forbes article by Mark Travers refers to a recently published study by the research team in which Prof. Andreas Herrmann participated.
The research by Kellen Mrkva, Eric Johnson, Simon Gaechter and Andreas Herrmann, published in the Journal of Consumer Psychology, found that the vast majority of Americans are loss avers, but that certain types are less avers than others. The study examined characteristics in which loss avers people differ from those of people at the other end of the continuum, and provides initial hints on how to to overcome this cognitive trap.
Knowledge, experience and education make people less vulnerable to loss aversion.
In all studies, more knowledge, experience and education was associated with less loss aversion, although people of all levels of knowledge, experience and education were averse to loss. For example, investment bankers, traders, accountants, business economists, etc. are less susceptible to the cognitive distortions caused by the phenomenon of loss aversion than people with less knowledge and experience in financial decision-making. In couples, the partner who manages the household’s finances and investments tends to be less prone to loss aversion, regardless of gender. Among car buyers, those who knew more about a particular car attribute (e.g. fuel consumption) tended to be less loss averse for this attribute but not for other attributes (e.g. comfort). In addition, older consumers showed higher levels of loss aversion in various measurements.
What are the implications of the loss aversion studies?
A large part of the existing literature on loss aversion was conducted with young, educated people at the university. This may have led to exaggerated estimates of loss aversion, according to some researchers. Data from the current study suggest the opposite: respondents who are older and less educated are more loss-averse, suggesting that research with students underestimates the size and importance of loss aversion.
Furthermore, the finding that older people are more loss averse has significant implications considering that the average age of the world population is increasing rapidly. Forecasts predict that between 2020 and 2055 the number of people over 80 years of age worldwide will more than triple (United Nations, 2017). It is therefore essential to better understand the relationship between age and consumer choice.
Forbes translates the study results into practical recommendations for overcoming the cognitive bias.
Building on the results of the study by the research team, Forbes has taken the implications a little further and has worked out the following recommendations for action:
1. Think long-term:
If you want to be less loss prone – even if you are older and less financially savvy – one option is to look at the decision from a long-term perspective. People are more likely to buy stocks and make investments if they think long-term rather than just looking at profit and loss in the present.
2. Do not let the media guide you too much:
Especially when the stock market is going wild, losses often attract more headlines and media attention than equally large profits. Even if we tend to focus our decisions on risk avoidance, we should not forget to analyze the equally available profits.
3. Bring in different perspectives:
If you’re hesitant whether to keep or sell the stock or keep or throw away an item, you might consider asking yourself, “What would my friend or neighbor recommend in this situation?” This form of taking on another perspective could help discarding insignificant possessions that is so unpleasant due to the loss aversion. Furthermore, when it comes to shares and investments, it is always a good idea to consult financial advisors to protect yourself from short-term wrong decisions.
We are pleased that Forbes magazine not only takes up the study but also enriches it with valuable recommendations for practitioners.
As The Stock Market Tumbles, Psychology Research Urges You To Avoid This Common Error
in: Forbes (09.03.2002)
Moderating Loss Aversion: Loss Aversion Has Moderators, But Reports of its Death are Greatly Exaggerated
in: Journal of Consumer Psychology, 2020
(Kellen Mrkva, Eric J. Johnson, Simon Gächter, Andreas Herrmann)
World Population Ageing 2017
United Nations, New York, 2017
Picture: Bild von kalhh auf Pixabay