How investors can overcome loss aversion

It’s one of life’s interesting quirks-our reluctance to part with something we possess. The first sofa my wife and I bought as newlyweds 25 years ago has languished in a corner of our garage for nearly five years. We’ve convinced ourselves that eventually one of our children will need it. In truth, it’s likely to still be there five years from now. 

This is a classic example of loss aversion, an all- too-human tendency to place an irrational premium on things we possess. The classic experiment that highlighted this tendency was a bet economist Paul Samuelson proposed: flip a coin; heads you win $200, tails you lose $100. An overwhelming majority of people faced with this offer refuse. However, if we do the math, it says it’s a bet we should make without hesitation {$200 x 50% = $100 > -$100 x 50% = -$50}. 

This dynamic isn’t just present in the research lab. One of the more interesting examples of loss aversion is recent research among professional golfers that shows PGA Tour pros are about 50% more likely to make a par putt of a certain distance as they are to make a putt of the same distance for a birdie.

For investors, loss aversion can take many forms. Here are just a few I see with prospective clients:

• Refusing to sell a stock at a loss

• Reluctance to leave an existing adviser despite inferior returns and service

• Buying extended warranties

• Paying significant repair costs rather than buying

• a replacement

I hope readers will add the topics we’ve covered in this series on investor behavior to their investment process. Being aware of how we are wired and the role emotion plays in our decision-making is half the battle in becoming a better investor.