Is loss aversion reducing your investment returns?
11 July, 2017
Like your first kiss, the day you lost £150 on your £10,000 investment is difficult to erase from your memory. But the exact day you got that £150 back may not have made the same impact. And as that £10,000 steadily grew over time, you remember being pleased, but if didn’t pack quite the same emotion punch as losing money.
If this sounds familiar, then you’ve experienced ‘loss aversion’, a term used by behavioural economists.
What is loss aversion?
Cold sweat when the markets go down, and little more than plain relief when they go up? Loss aversion is where individuals are far more miserable about seeing losses on their investments than they are happy about making gains. In other words, the pain of losing is twice as powerful as the pleasure of gaining. This means people will tend to take more extreme measures to avoid a loss, than they will to achieve a gain.
Gotta risk it to get the biscuit
The more risk you take with an investment, the higher the potential gains (and losses). This is an investment rule as old as stock markets themselves.
But you should know that by avoiding losses, you also take on some risks (https://www.boringmoney.co.uk/learn/articles/stocks-versus-cash-is-it-worth-the-risk/).
Number one on this list is inflation risk. In trying to avoid losses, many people will keep too much money in a cash account. Cash is seemingly safe. If you put £10,000 in an account in January, the worst case scenario is that you have £10,000 in December; if you shopped around for a decent interest rate you might have as much as £10,300.
But those days are behind us now. Interest rates have been very low for almost a decade and in spite of recent rate rises, they remain below 1%. At the same time, inflation has exceeded 2% since 2017 and is expected to remain high. Leaving your money in cash could mean that you see the real value of that money diminish over time.
The warm familiar British blanket
The official term for this is ‘concentration risk’. To reduce your risk, you may gravitate towards those investments that are familiar. That’s likely to mean cash and investments within the UK. This leads to a currency concentration – meaning your portfolio has been exposed to the full effects of sterling depreciation in the wake of the Brexit vote.
The value of sterling dropped by 10% after Brexit; if you had investments in other currencies you will have protected the real value of your money. By spreading your investment around the world you can also get exposure to exciting sectors such as technology that are under-represented in the UK, or fast-growing regions such as Asia.
So what to do about it?
Don’t forget to enjoy the highs. Take a minute and marvel at what you have now versus what you had before, and try to remember that every downturn has reversed itself so far. When you’re choosing funds or robos to invest in (https://www.boringmoney.co.uk/isas-pensions/isas-pensions/), make sure you’re exposed to a blend of different countries and currencies. If you're in a fund that has this already, don't panic-sell if things go south for a bit. It's the very worst time.
Read next: Where there are bandits, there is alpha (https://www.boringmoney.co.uk/learn/articles/where-there-are-bandits-there-is-alpha/)
This article appeared in its original form on the Moneyfarm Blog (https://blog.moneyfarm.com/en/)