There Is No Need to Go Down With the Ship
Loss aversion is what leads people to hold onto items long past their usefulness and to refuse to part with an investment until it gets back to what they paid for it. For business owners, it can also mean holding onto an underperforming division, a stalled product line or an outdated succession plan simply because letting go feels like admitting defeat. Avoiding losses may sound wise, but taking it too far can keep you from reaching your financial goals.
The Pain of Loss Aversion
As the name suggests, loss aversion is our instinct to prioritize avoiding losses over almost anything else, even a comparable gain. It is the comforting pull of the status quo, and it is often why owners who lived through a market downturn or a difficult stretch in their business become more hesitant to take on risk going forward.
This aversion touches many parts of life, making it hard to part with everything from an aging piece of equipment to an underperforming investment. Research has shown that we tend to believe the things we own are worth more than identical things we do not own, simply because we own them. Loss aversion can also open you up to unnecessary risk. The fear of loss is often described as twice as powerful, psychologically, as the good feeling generated by an equivalent gain, and that fear can push people toward decisions that do not serve their long term interests.
Loss Aversion Might Be Playing a Role If
The average person is only willing to risk a potential loss if they stand to gain at least double that amount in return.
Source: Journal of Experimental Psychology, Vol 144(1), Feb 2015
Is Fear of Loss Holding You Back?
Money is one of the things people fear losing most, which makes loss aversion especially influential when it comes to your finances. A well known 2007 study led by a Stanford psychology professor found that brain activity spiked when participants faced potential losses, more so than when they faced comparable gains.
That fear can hold you back from important long term planning. An unwillingness to sell an investment for less than you paid can keep you clinging to a declining stock or a depreciating asset. It can also make it hard to admit that a purchase, whether a piece of real estate or an investment in a new venture, did not pan out the way you expected.
When Loss Aversion Factors Into Your Financial Decisions
In studies of how people react to gains and losses, participants’ reactions to losing a given amount were roughly twice as strong as their reactions to gaining that same amount.
Source: Kahneman, Daniel. Thinking, Fast and Slow. New York: Farrar, Straus and Giroux, 2011
The Guardrail Against Loss Aversion
An overly strong aversion to loss can hold back a financial plan’s progress, both for your business and your family. While it is natural, and often prudent, to want to avoid loss, letting that fear dominate your decisions can actually lead to the very outcome you are trying to prevent.
Cultivating a healthy relationship with risk can be the key to long term growth and a useful counterbalance to loss aversion. If you have been burned before, by the market or by a business decision, it helps to take the long view and look past that setback rather than dwell on it.
It also helps to work with an objective third party who can offer perspective alongside financial planning and investment support. Whatever life, or your business, or the markets bring, having someone you trust in your corner can help keep you on track toward your long term goals.
