Could loss aversion be harming your investment returns?

Uncertainty and volatility are part and parcel of investing in the stock market, but that doesn’t mean to say that they’re comfortable to experience.

Though it’s natural to feel a little nervous during periods of uncertainty, if your fear becomes too big to manage, it can begin to influence your investing decisions. Under these circumstances, the emotions you’re experiencing can create a cognitive bias known as “loss aversion”, and this can hinder your efforts to grow your wealth and achieve your goals.

Read on to learn more about how loss aversion can affect you and how your financial planner could help you to keep it in check.

The fear of losing money can cause you to take less risk on your investments

All investors can be vulnerable to loss aversion, no matter how long they have held investments for. This is because research shows that humans tend to feel the pain of a loss more acutely than they feel the joy of a gain.

The phenomenon was first observed by psychologists Amos Tversky and Daniel Kahneman in the 1990s. In their study, participants found that their ability to make sensible financial decisions was negatively affected when they focused on their fear of losing money.

In your day-to-day life, loss aversion can hold you back from taking a sensible level of risk on your investments, which may harm the potential returns that your money could generate over the long term.

For example, imagine you are offered a guaranteed payment of £1,000, or a 90% chance of winning £2,000.

The 10% chance of winning nothing might lead you to opt for the guaranteed lower payment rather than take the small risk on winning the larger amount. In this example, you can clearly see how loss aversion has influenced you to reduce your potential gain.

Over the long term, this could sabotage your attempts to grow your wealth, perhaps making it more difficult to achieve your financial goals.

Loss aversion can be more difficult to manage during times of uncertainty

When global events create uncertainty on the stock market, you might find that the fear of losses is more powerful than the lure of achieving returns.

Allowing these worries to grow and affect your decisions can mean that you opt for lower-risk investments that have fewer opportunities to grow your wealth at the pace you might need to be able to achieve your long-term goals. While you do need to be sensible about the level of risk you expose your wealth to, taking less risk on your investments for fear of losing money can reduce the potential that those investments have for growth.

Consequently, you may find it challenging to grow your wealth adequately to achieve your goals in the time frame you would like.

Your financial planner can help you to make sensible decisions about your investments

Though we all like to think of ourselves as rational thinkers, sometimes our emotions can get the better of us. Even when you have all the facts about loss aversion, it can still be challenging to manage this cognitive bias alone.

Your financial planner can be a helpful guide for you during times of market volatility when your emotions could become more difficult to manage alone. For example, they can help you to feel reassured about the level of risk you are taking on your investments; by investing in a range of asset types, sectors, and locations, you can mitigate the risk that your wealth is exposed to during times of uncertainty.

They can also help you to make sensible decisions about your investments, during both good times and bad, ensuring that any changes you make to your portfolio are done with your long-term goals in mind rather than short-term fear.

Above all, working with your planner can give you the confidence to navigate periods of market uncertainty or volatility, knowing that you are making the most sensible decisions for you.

Get in touch

To learn more about how we can support you in creating an investment portfolio that can withstand short-term market volatility and help you to achieve your long-term goals, please get in touch.

You can email us at info@harperlees.co.uk or call 01277 350560. We’ll be very happy to help.

Please note

This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.