The Nobel prize-winning psychologist Daniel Kahneman died at the age of 90 at the end of March. He became synonymous with behavioural economics and finance even though famously he never took a course of economics.
In his best-selling book Thinking, Fast and Slow he debunked the notion that people are rational beings who act out of self-interest but rather they act based on instinct.
In finance however his most important finding of all is that money lost is not the same as money gained. Losses are in fact more than twice as painful as gains are pleasurable.
In a conference once, he asked the attendees – if you would lose $100 in a coin toss if it came up tails, how much would you have to win on heads before you’d take the bet? And most said, $200 or more.
Loss aversion is perhaps the most important money concept of them all. Losses can cause panic in the markets. They can change your perception of risk. Losses in the present can impact your investment behaviour in the future. The fear of losses can cause investors to invest in portfolios that have very low returns. They can also force investors into holding onto losing positions because they won’t sell until the break even. Inflation for example is a loss of purchasing power which explains why it’s such an emotionally charged topic.
It’s important if you are to be a successful investor over the long term that you have the ability on occasion to deal with some losses. Perhaps the most important way to deal with this bias is to recognise how loss aversion can impact your feelings and reactions.
Everybody has their own character flaw or personality disorder when it comes to money emotions.
Managing those emotions is even more important than how you manage your portfolio. If the process is difficult, working with an adviser can help.
- This blog is for information purposes and does not constitute financial advice , which should be based on your individual circumstances
- The value of investments may go down as well as up and you may get back less than you invest
