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What is Loss Aversion?
Loss Aversion refers to our preference to avoid a loss because the associated pain is more intense than the reward felt from a gain.
The Psychology of Loss Aversion
Behavioral finance research has found social, emotional and even cognitive factors can affect a person’s financial decisions and stand in the way of their investment success. Those factors, also called biases, are the subconscious tendencies that may drive an otherwise rational person to think or act irrationally.
With loss aversion, people go to great lengths to avoid a loss because the associated pain feels stronger than the reward felt from a gain. In fact, studies show that the pain of a loss is almost twice as strong as the reward felt from a gain. Put another way, losing one dollar feels twice as bad as winning one dollar feels good.
Fear Drives Investors Into Cash
As emotional investors, we tend to make decisions to avoid the pain of loss. During the last two market pull-backs investors panicked and pulled their money out of the market—contributing to large increases in cash and cash equivalents. To avoid more losses after a market crash, fearful investors may be tempted to move their investments to a place they perceive as a safe haven— such as cash, cash equivalents or even stuffed under their mattresses.
CASH INCREASES DURING MARKET PULL-BACKS1
Perceived Safety may Come at a Cost
But, what investors may not realize is that this “perceived” security comes at a cost. Enter inflation. Investors may be surprised to learn that, once inflation is factored in, staying in investments they may consider more secure while they wait out stock market volatility may actually lead to an erosion of purchasing power.
WHAT CAN YOU DO ABOUT IT?
One of the best ways to make better financial decisions is to work with a financial advisor. A financial advisor will take the time to understand your individual needs and create an investment strategy that’s tailored to your specific goals, your individual situation and your risk tolerance.
As you navigate the market, an advisor can also help you keep your emotions and biases in check and stay on track with regular portfolio reviews and adjustments.
Next Steps
Every day we are faced with decisions—some are easier to make than others. Learn more about behavioral biases and the impact they can have on investment portfolios.
Other Investor Behavior Videos
Access more short videos to see how behavioral biases show up in our everyday lives.
Watch NowImportant Legal Information
All investments involve risk, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.
This material is general in nature and intended for educational purposes only; it should not be considered investment advice or an investment recommendation.
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- Source: Federal Reserve Bank of St. Louis.
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Franklin Distributors, LLC. Member FINRA/SIPC. Prior to July 7, 2021, Franklin Templeton Distributors, Inc., and Legg Mason Investor Services, LLC served as mutual fund distributors for Franklin Templeton.
