Loss aversion is the phenomenon of how we feel a loss significantly more than an equivalent gain. Economic Nobel Prize winner Daniel Kahneman, wrote that “The concept of loss aversion is certainly the most significant contribution of psychology to behavioral economics.” What we find with loss aversion is people will go at great lengths to avoid a loss of some kind even though the gain is just as likely. Therefore, the pain of a loss can feel nearly two times greater than a win. Let’s put that into dollars. The amount of “feels” I get from seeing my $50,000 account deplete to $25,000 (-50% loss) is the same amount of “feels” I get from seeing my account grow to $100,000 (+100% gain).
Loss aversion leads to cash pile ups, particularly in bear market situations. We see this by analyzing the inflows and outflows of mutual funds (how much people are buying into or selling out of their holding). When the market starts to tank, we witness investors selling out of their positions. Although we’ve all heard the phrase buy low sell high, what most investors do is the opposite due to the pain this experience puts upon them. As financial advisors, it’s our job to remind people that seeing your portfolio at a loss is not permanent, but selling your portfolio at a loss is.
Loss aversion is no different than the conversations we have with our superiors. Our boss will praise us for the good work we did on the project. We feel good about the tribute and move on. Our boss then tells us how we can improve for next time. ‘NEXT TIME?!? NOW SHE’S PLAYING GAMES WITH ME BECAUSE OBVIOUSLY THERE WON’T BE A NEXT TIME. SORRY BABE, NO BONUS FOR US THIS YEAR!!!’
When (notice how I did not say IF) your portfolio is down 20%, 30%, or 40%, evaluate how strong your feelings are, and how they would be if your portfolio was up 20%, 30%, or 40%. When your portfolio is up, do you liquidate the entire portfolio to invest in the best performing stock? I sure hope not! So why would you liquidate your entire portfolio when the opposite is true? If you find yourself making major shifts in your portfolio or anything financial due to a loss you are experiencing, check yo’self before you wreck yo’self my dear. Consult with an expert before making anything permanent.
Herding mentality is when investors follow what they perceive other investors are doing. Decisions are typically made by emotions or instinct (fight or flight) rather than individual analysis.
Herding mentality leads to people making investment and financial decisions that are not taking into account their own situation. Your coworker may make you think everyone is getting into this new investment, but does that mean you have to? No, absolutely not. For one, your coworker is never telling the whole story, and secondly your coworker has no idea about your financial situation. Herding mentality leads to FOMO. You’ll act on a decision so you don’t miss out on what everyone else is doing. The reality is that NOT everyone is doing it, and that NOT everyone is benefiting from it.
I’m not a stranger to herding mentality. As with all of our biases, it goes beyond our investments. For example, I had an old coworker create our wedding registry. I had no idea what to ask people for, I just thought everyone asked for kitchen stuff which I knew my coworker was an expert in. She was (and still is) an excellent chef. The registry was then created for someone with her capabilities. At the time, I had very little skill in the kitchen (ask Dan about the fish tacos I made him when we first started dating…) What happened when we opened our wedding gifts? We got a bunch of stuff that we never used. Instead of evaluating my own life and our own needs, I went with someone else's.
Sorry to our friends and family who are reading this. If you got us some unconventional kitchen dishware or utensil, well… lets just say someone else is enjoying that much more than we ever would. Lesson learned.
Herding mentality is extremely difficult to point out. It seems so obvious in hindsight, but in the moment it truly feels like you’re making the best decision for your situation. When evaluating this bias, look for reasons why you are making this decision. Is it because it’s in your best interest? Or is it because everyone else is doing it?
This concludes our Money Bias Series blog! What a journey it’s been. Use these blogs as a resource to understand what you battle as an investor every day. No one is free and clear of these biases. Elite investors, financial advisors, pundits on TV, you, your partner... we all have them. The more aware we are of their existence within us, the better of our investor behavior becomes. As humans, our cognitive and psychological behaviors have a way of…getting in the way. These behaviors don’t sit back during our money making decisions, if anything, they see it as their time to shine. Educate yourself, protect yourself, and grow from each experience you face.
If you need help along the way, we’re right here.
Overconfidence Bias and Self Attribution Bias
Hindsight Bias & Confirmation Bias
The Narrative Fallacy & Representative Bias
Framing Bias & Anchoring Bias
Disclaimer: This article is for informational purposes only and is not a recommendation of Fyooz Financial Planning, Natalie Slagle CFP®, or Daniel Slagle CFP®. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be assumed that future performance of any specific security, investment product or investment strategy referenced in the article, either directly or indirectly, will be profitable or equal to the corresponding indicated performance level(s). No portion of the article shall be construed as a solicitation to buy or sell any specific security or investment product or to engage in any particular investment or financial planning strategy. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.