Raskin Planning Group

Making Irrational Financial Decisions is Only Human (Part 2): Loss Aversion

{4:30 minutes to read}

Part 1 of this article series takes a deeper look at irrational financial decisions and the reasons for them according to behavioral economics and financial research. Ultimately, the findings show that anchoring can be detrimental to long-term objectives.

One of the first and most interesting tenants of behavioral finance is the concept that a loss produces “pain” greater than the “pleasure” of a win. In other words, losses have more emotional impact than an equivalent amount of gains.

For example, the amount of pleasure gained from finding $50 should be the same as if you found $100 and then lost $50. The completely rational person would find both situations equally pleasurable, since both situations net $50. However, in most cases, people would prefer the first example.

Loss aversion helps us explain irrational financial behaviors:

  • A doctor decided to earn less income so he didn’t have to pay more taxes. In this situation, the doctor believed the pain of paying taxes (a perceived loss) is greater than the pleasure of additional after-tax income.
  • Investors that live in “high-tax” states often purchase bonds from the state they live in so they can avoid paying income taxes on their state’s municipal bond income. In fact, a diversified portfolio of municipal bonds from around the country can provide more after- tax income with less risk than a state specific bond portfolio. Again, the pain of loss (paying taxes) is greater than the pleasure of greater income.
  • The fear of loss keeps many investors on the sidelines, where they buy low-risk CDs or government bonds instead of stocks. This strategy is detrimental to their long-term objectives as low-risk investments rarely provide returns that will help clients meet their financial planning objectives.
  • Investors will often hold onto losing stocks for too long and sell winning stocks too soon. Logically, a rational investor would keep the winning stocks and sell the losing stocks.
  • Short-term losses in a diversified portfolio can cause investors a great deal of angst. Markets always recover and rational investors would be wise to stay fully-invested during periods of volatility. Nevertheless, the pain of loss can be so significant that some investors will sell their stocks after a large decline (locking in losses) and miss the subsequent recovery. After markets recover, some of these same investors will come back into the markets, repurchasing stocks after they have bounced back to their previous high. This “buy high and sell low” investment strategy isn’t usually very successful.
  • Globally diversified portfolios consist of different kinds of stocks and bonds and should, over a long period of time, offer investors a reasonable return. Nevertheless, these diversified portfolios will have holdings that suffer losses and other holdings will experience gains during any period of time. Portfolios might have net positive returns when total gains are greater than total losses. Despite these positive total returns that help the client meet their financial objectives, clients tend to feel dissatisfied because the pain of loss is greater than the pleasure of the gain.

Loss aversion is real for most people.

At the Raskin Planning Group we understand this tendency to avoid loss. Nonetheless, we believe that accepting some risk is necessary if you want your family to achieve financial independence. Managing that risk appropriately and staying focused on long-term objectives is our focus. An investment strategy that is rational and objective gives you the best opportunity for success. Please call the Raskin Planning Group at 617-728-7433 with questions.

Peter Raskin is a registered representative of Lincoln Financial Advisors Corp. Securities offered through Lincoln Financial Advisors Corp., a broker-dealer (SIPC). Investment advisory services offered through  Sagemark Consulting, a division of Lincoln Financial Advisors Corp., a registered investment advisor. Insurance offered through Lincoln affiliates and other  fine companies. 125 Summer Street, Suite 1400, Boston, MA 02110  617.728.7444 Rasking Planning Group is not an affiliate of Lincoln Financial Advisors. CRN-1325918-101515