choosing-lottery-numbers

People who lose $1,000 feel bad. People who find $1,000 feel good. But the person who finds $1,000 doesn’t feel as strongly as the person who has lost money. In fact, the loser weighs on the issue twice as heavily as the gainer.

That’s loss aversion.

Sociologists and anthropologists surmise this tendency helped humans survive in earlier environments. Think about hunting down a large beast—the opportunity for gain has to be much bigger than the potential danger to make it prudent for people to take the risk.

Warning signs

Those who are loss-averse are short-sighted. They worry about short-lived and minor losses in the next week or month, even if the game at hand is set to last for years.

Look at Germany, where 90% of the population holds no equities, showing a marked preference for fixed-income products. This happens despite the fact that in the long term, equities outperform fixed income. So, by taking this timid approach, Germans are denying themselves superior investment performance.

At the same time, 35% of Germans regularly buy lottery tickets. So they show a preference for both very safe and very risky investments, but don’t hold enough in the middle, like equities.

Help your clients

If your clients appear excessively loss-averse, make them feel more comfortable about taking risk and help them to think long-term.

Likewise, if your clients insist on holding concentrated portfolios, appeal to their sense of loss aversion to help tone down their aggressiveness. Get them to imagine how badly they’d feel if they lost a lot of money, and frame that loss relative to an aspiration—lay it on the line that they won’t have the kind of retirement they want.

Here’s another way to measure clients’ loss aversion. Ask them if they’d be comfortable with a 50/50 coin toss. Heads, they win $10,000. Tails, they have to pay you $10,000. Is this a bet they’re comfortable with? If not, ask them the biggest payment they’d be comfortable with. Then you can measure the degree of loss aversion by dividing $10,000 by the amount chosen.

You’ll play this game more than once, and with equities, you’ll be playing over and over. The law of averages works in your favour over the long term. If you were to agree to go $10,000 gain to $5,000 loss, and play many times, you’d do extremely well.

Reframing the debate is the name of the game. You need to develop techniques for diagnosing the psychological vulnerabilities of clients, and then nudge them to do something sensible.

Originally published in Advisor's Edge