We’re all averse to losses to some degree. We avoid making investment decisions because we’re afraid we’ll make the wrong choices. We hang onto beaten-down stocks because it's too painful to sell and make those losses “real.” That’s not unusual.
But predicating your financial planning and investing choices on avoiding losses, rather than taking the right sort of risks to achieve gains, can hamstring your financial plan in surprising ways.
For example, a fear of loss can translate to an overly conservative investment strategy, or even a reluctance to anticipate the loss of your salary by making a prudent retirement spending plan.
Here’s how to recognize when loss aversion is clouding your financial judgment—and what you can do to prevent a fear of loss from derailing your retirement plans.
What is loss aversion, really?
“The regret we feel when we experience a financial loss can be very painful,” notes Rob Williams, managing director of income planning at the Schwab Center for Financial Research. So painful, in fact, that people tend to work harder to avoid an impending loss than they do to achieve a gain. And loss aversion can be particularly strong as you approach retirement.
While the average person is two times more averse to losses compared to how much they value gains, retirees are five times more sensitive to loss, according to a study by AARP and the American Council of Life Insurers. This makes sense, given that the closer you are to retiring, the harder it can be to shrug off a market loss because you have less time to recover, Rob says.
Still, giving into the impulse to avoid loss, however natural, can sometimes lead to poor investment choices. You may put assets into ultra-conservative securities to try to protect yourself from market volatility. Or you may panic whenever an investment drops, and sell at a loss. Or you may resist parting with a substantial amount of cash to buy an annuity (or hire a financial professional), even though that may be exactly what your plan needs.
Note that there is a healthy self-protective instinct at work here, but when it’s carried too far you run the risk of other, less obvious losses (for instance, missing out on potential market gains or having a less-than-optimal financial plan).
Not everyone has an equally hard time coping with loss, of course. Personality traits such as optimism and confidence can override the aversion response, just as worry or pessimism may accentuate it, says Victor Ricciardi, co-editor of Investor Behavior: the Psychology of Financial Planning and Investing.
And experience plays a role: Investors who have lived through several bear markets and severe shocks to the stock market may also have a more pronounced negative response to loss, he says.
And while ostensibly there’s nothing wrong with making conservative choices, you don’t want fears of loss to immobilize your plan or skew your judgment. Fortunately, there are ways to overcome loss aversion so that it doesn’t sabotage your long-term financial security.
Carve your portfolio into “buckets.” Partitioning your assets into separate buckets, each with different goals and risk profiles, can help you manage real risk without succumbing to an irrational fear of loss, Rob says.
He suggests the following strategy for anyone living off their portfolios: Keep enough cash to cover one year’s worth of expenses in a checking account; invest two to four years’ worth of expenses in short-term bonds or cash equivalents; and invest the remainder of your assets based on your expected longevity, risk tolerance and other goals.
“If you know you have four years of stable assets to cover living expenses, you may be more comfortable investing other assets in securities that carry higher risk, but have the potential to provide the growth you need during retirement,” Rob says. “Making sure that your portfolio is invested for a broad range of returns will make you more immune to loss-aversive behavior that focuses on investing only for safety and wealth preservation.”
Make a plan you can live with. It can’t be said often enough: Creating a plan and sticking to it can keep you from reacting in panic to a temporary downturn in the market or a crisis abroad—or worrying about things you can’t control, like interest rates and inflation.
“Markets will always be uncertain,” Rob notes, “but if you develop an asset allocation designed to accommodate risk and change, you’re more likely to stay on course.”
In case you need an extra incentive to work with a financial professional—or work more closely with the one you have—this is it. A trusted, outside source can provide perspective on the news and remind you of your goals. That’s a smart way to prevent the downward cycle that can start with fear of financial loss.
Consider fixed immediate annuities. An annuity can protect you from outliving your assets by providing a predictable income stream. Equally important, it can relieve the anxiety that a market downturn might compromise your lifestyle. “Payments from fixed immediate annuities are higher if you purchase them in your 70s, which is about the time when predictable, guaranteed income may be most helpful,” Rob says.
Of course, you’ll have to surrender a portion of your assets to buy a fixed immediate annuity, and that can feel pretty uncomfortable if you're loss-averse. Remind yourself that the financial security it provides can free you from overreacting to potential losses in your other investments. And the assets you use to purchase the annuity buy you a stream of income that is guaranteed to last the rest of your life, regardless of how long you live, subject to the claims-paying ability of the issuing insurance company.
A quarterly review is enough. The more often you check your portfolio, the greater the likelihood that you’ll see a loss during normal market fluctuations. If you’re prone to selling in response to even short-term market dips, one easy solution is to stop monitoring your portfolio obsessively.
Instead, evaluate and rebalance quarterly, which is often enough to maintain your asset allocation in up and down markets—even when that means paring your best performers and adding to securities that have taken a hit.
The upside of loss aversion
Not all loss aversion is bad. If you’re near retirement or have already made the transition, reducing investment risk—and potential losses—is wise. “The performance of your portfolio just prior to and in the early years of retirement can have profound effects on the success of your financial plan,” Rob says. “If the market falls and you sustain heavy losses because you’re aggressively invested in riskier asset classes, your portfolio may never recover sufficiently to support you over the next 30 years.”
As with many things in life, it’s important to find the right balance. “With a solid financial plan and an asset allocation that balances stability and growth, you can spend your retirement doing more important things than worrying about whether inflation will tick up or the market will turn down,” Rob says.
At the same time, recognizing loss-aversion as part of the natural human reaction to uncertainty will help you stay on target as you prepare for retirement.