The Costs Of Loss Aversion on Investment Performance

Most people fear losing money than missing out on gains. It’s known as loss aversion. This article explains the costs of loss aversion and why it is so widespread. Of course, it’s the type of article that often appears at market tops and makes those who fear losses more confident they are right than they were before.

Loss aversion can cause investors to make ultra-conservative decisions. I know one investor who has had $1 million dollars sitting in a bank earning essentially nothing for 10 years because he fears that if he buys stocks, prices might go down. He would have more than $2 million now if he hadn’t been so paralyzed by loss aversion.

We see widespread evidence of loss aversion in the stock market these days, with investors and analysts fretting that, with the S&P 500 SPX, -0.24%  at or near record levels, and double its level six years ago, a crash is inevitable. Many have pulled out of the market because they fear losing money more than they fear not making money. The pain of a prospective loss is much more powerful than the possible pleasure from a potential gain. Better to give up the possibility of a 30% gain than to risk a 20% loss.