The effects of loss aversion bias in investing.
Biases are the filters through which we make decisions about everything—from what movies we watch, to what we have for lunch, to what we do with our money. All thoughts are filtered this way. In fact, it's impossible to make a purely unbiased decision.
What is loss aversion bias?
Loss aversion bias drives us to prioritize avoiding losses over earning gains. But when it comes to money matters, loss aversion can lead to portfolios that are potentially too conservative. People often need an extra—and sometimes significant—incentive to take financial risks that might result in a loss.
Loss aversion is a major reason why many investors underperform the market.
The problem: A conservative portfolio may sacrifice the growth potential you need to reach your long-term goals.
Loss aversion is the reluctance to realize a loss because the emotional jolt of said loss is about twice as powerful as the joy from a gain.2
In the down year of 2022, the average equity investor lost 21.17% during a year when the S&P 500® Index lost 18.11%, a gap of 3.06%.3 This may be due to investors selling stocks out of fear and missing out on any market rebound.
In 2022, many 401(k) participants put new money into assets they presumed to be safer while pulling money out of equities.4
Keep biases in check by working with a Schwab investment professional.
A Schwab investment professional can be a sounding board for your investing goals and decisions, working with you to overcome any emotional or cognitive biases you may have. We can work with you on your terms, whether it's building a one-time plan, providing ongoing support, or introducing you to new products and solutions.
4 ways to remedy loss aversion bias.
-
Take emotions out of the process.
An investment professional can help you set objectives for buying, selling, and rebalancing your portfolio. Review and rebalance your portfolio regularly to keep your long-term allocation strategy intact, rather than trying to time the market.
-
Control what you can.
Take control of things that impact your overall portfolio performance. For example, you may be able to improve performance by controlling investing costs and managing taxes. Take advantage of these opportunities.
-
Stay clear of financial and social media.
Constantly monitoring the market is stressful. It also increases the likelihood of making costly short-term mistakes or taking too little risk, since the chance of short-term loss is higher than the probability of loss over the long term.
-
Avoid making decisions under stress.
Find ways to override your reactions to emotional stress, such as calming influences that help you take a breather (literally and figuratively) when volatility triggers fear. This could help you avoid making decisions—and potentially mistakes—in a highly charged emotional state.
Take emotions out of the process.
An investment professional can help you set objectives for buying, selling, and rebalancing your portfolio. Review and rebalance your portfolio regularly to keep your long-term allocation strategy intact, rather than trying to time the market.
Control what you can.
Take control of things that impact your overall portfolio performance. For example, you may be able to improve performance by controlling investing costs and managing taxes. Take advantage of these opportunities.
Stay clear of financial and social media.
Constantly monitoring the market is stressful. It also increases the likelihood of making costly short-term mistakes or taking too little risk, since the chance of short-term loss is higher than the probability of loss over the long term.
Avoid making decisions under stress.
Find ways to override your reactions to emotional stress, such as calming influences that help you take a breather (literally and figuratively) when volatility triggers fear. This could help you avoid making decisions—and potentially mistakes—in a highly charged emotional state.
Put your new insights into action with either managed or self-directed solutions.
Learn even more on our behavioral finance podcast.
Choiceology®
Wharton professor Katy Milkman shares true stories involving high-stakes moments and explores the latest research to help you make better judgments and avoid costly mistakes.
