Loss aversion bias—2-minute video

Is the loss aversion bias affecting your clients? Help them find out by sharing this short, client-approved video, which provides actionable insights and guidance on how the loss aversion bias can potentially influence our investment decisions. Then consider exploring the behavioral finance program for advisors linked near the bottom of the page for follow-up tools.

Loss aversion bias in perspective.

Key Takeaways:

• Loss aversion drives people to prioritize avoiding losses over earning gains.
• Behavioral scientists have found that the pain of a loss is felt more strongly than the pleasure of an equivalent gain.
• Loss aversion can lead to portfolios that are too conservative.
• This conservative tilt may not give clients the growth potential they need.
• By teaching clients about loss aversion, advisors can more easily steer them toward more rational investment decisions.

What is loss aversion bias?

Loss aversion is the tendency to avoid losses over achieving equivalent gains. Broadly speaking, people feel pain from losses much more acutely than they feel pleasure from the gains of the same size. Loss aversion bias typically shows up in financial decisions: people often need an extra—and sometimes significant—incentive to take financial risks that might result in a loss.

For example: the second half of 2022 saw significant volatility, with the S&P 500® Index dropping more than 10% between August and October. Those losses might have led some investors to believe the worst was yet to come; however, if they were not invested in January 2023 they might have missed out on the S&P 500’s 15% returns by early August.

Nobel Prize–winning economist Daniel Kahneman illustrated the psychology of loss aversion bias in a simple experiment with his students: he told them that if a flipped coin lands on tails, they would lose $10. Then he asked them how much they would need to win to make the coin flip worth the risk of losing $10. The answer, he said, was typically more than $20.

At a glance: Loss aversion bias

Loss aversion is an emotional bias. It describes the tendency to prioritize avoiding losses over earning gains.

Loss aversion can make investors overly conservative. During the down year of 2022, many 401(k) participants put new money into assets they presumed to be safer while pulling money out of equities.*

The big problem: The short-term protection of a conservative portfolio may sacrifice the growth potential investors need to reach their long-term goals.

How advisors can help: Advisors can educate investors about how markets move over time.

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* Alight; “Alight Solutions 401(k) Index; 2022 Observations,” 2022. URL: https://www.alight.com/thought-leadership/alight-solutions-401k-index-full-year-2022

** Schwab Asset Management; Bloomberg. Data as of 08/18/23. This chart illustrates the growth of $10,000 invested in an aggressive portfolio—defined as 80% stocks/20% bonds—and in a conservative portfolio—defined as 50% stocks/50% bonds—for the trailing 10 years ended 12/01/22. Returns include reinvested dividends and interest. The S&P 500 Index was used to represent stocks and the US Bloomberg Aggregate Bond Index was used to represent bonds. Portfolios rebalanced annually. Please see schwabassetmanagement.com/glossary for index information. Indexes are unmanaged, do not incur management fees, costs and expenses (or “transaction fees or other related expenses”), and cannot be invested in directly. This hypothetical example is only for illustrative purposes. Past performance is no guarantee of future results.

Why does it matter?

Loss aversion can result in clients avoiding risk, leading to overly conservative portfolios that do not deliver the returns they need to achieve their goals. It can also push clients to sell during a stock market downturn simply to avoid further losses—which could mean they miss out on potential gains if the stocks they have sold rebound.

Conversely, loss aversion can lead clients to hold on to investments that have declined in value to avoid realizing a loss in their portfolio, even when selling would be the prudent decision.

Loss aversion is a major reason why so many investors underperform the market. For example, in 2022—one of the worst years for stocks since 2008—the average equity investor lost 21.17% during a year when the S&P 500 Index lost 18.11%, a gap of 3.06%, according to the financial research company DALBAR.¹ These excess losses may be attributed to investors selling stocks out of fear of further losses and potentially missing out on any subsequent market rebound.

What can you do about it?

Loss aversion is rooted in a deep-seated instinctual impulse to avoid pain. Making decisions before market volatility has a chance to play on clients’ emotions can help keep them from making emotionally charged decisions. Work with your clients to set up guidelines and objective rules for buying, selling, and rebalancing, particularly when facing difficult market conditions that require a more systematic approach. For example, agree that you won't sell holdings unless it falls by a certain percentage.

Additionally, consider suggesting to clients with an especially strong emotional bias to go on a media diet. The financial media tend to focus on dramatic short-term ups and downs in the market rather than on longer-term performance trends. Staying clear of the financial news can help keep clients from experiencing the fear that may lead them to make harmful short-term decisions.

Omar Aguilar, Ph.D.
President, Chief Executive Officer, and Chief Investment Officer