There’s good news and bad news — which do you want to hear first?
Chances are, three-quarters of you want to hear the bad news first.1 Why? Simply put, bad events signal a need for change, good ones don’t. This phenomenon is what this article will help to uncover.
The bad news is: one of the most significant tendencies clients have when investing is called “loss aversion.” Research shows people tend to feel pain from losses about twice as strongly as they feel pleasure from gains.2 It’s a powerful bias that can be an important motivator in client decision-making. When they feel this pain during tumbling markets, they often act impulsively and “fly to safety.” For clients getting ready for retirement, the strong desire to avoid loss could cause them to miss out on portfolio growth opportunities and take emotional actions after a loss that are contrary to their long-term investment goals. And for retirees, because they’re no longer working, they’ll likely have a strong desire to avoid loss in the hopes that they won’t outlive their savings.
The good news is: there are several strategies you can use to manage the impact of loss aversion.
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Loss aversion and client portfolios
A closer look at loss aversion
Loss aversion refers to 3 distinct but related aspects of human behaviour. Our tendency to:
- Avoid losses. We’re prone to avoid situations that could lead to a loss, even if the situation could potentially mean a greater reward.
- Take action when losses occur. A loss receives more attention and mental processing than good things.3 The urgency to act quickly can lead to poor decisions in a long-term investment portfolio context. Despite best intentions to stick with a long-term plan, negative short-term events can have a significant impact on many clients.
- Seek certainty. Our brains don’t like uncertainty; we steer toward certainty and feel rewarded when we achieve it, even if we may be better off over the long-term to remain uncertain.
Loss aversion and client portfolios
Assessing risk tolerance is foundational to building good portfolios and loss aversion is a key component needed to make that assessment. Risk tolerance includes both the willingness and the capacity for taking risk. All things being equal, clients with higher loss aversion will have a lower risk tolerance because the pain of loss makes them less willing to accept risks. However, clients who understand how taking prudent risks can help them meet their long-term objectives may be willing to accept risks they would otherwise reject — not because their natural loss aversion is gone but because they know that dealing with the discomfort caused by volatility is in their best interest.
- Half of investors (53%) view themselves as risk averse and conservative (52%) in their investing approach.
- Half of Gen Xers (49%) would settle for lower returns if it meant less volatility in their investments.
Source: The 2016 Market Sentiment Report by Sun Life Global Investments.
By understanding the different elements of loss aversion, you’re in a better position to manage the impact it can have on clients and their investment portfolios.
How you can counter loss aversion bias
Educating clients about the need for growth, diversifying their portfolios and including wealth products with guarantees in their plans can help manage the impact of loss aversion. Embracing and understanding loss aversion can reassure clients that you understand their fears and needs. It helps ensure they stay invested and reap the rewards of long-term portfolio growth.
Learn more about this powerful bias and the strategies to overcome it in Sun Life’s newest Bright Paper: Loss aversion and client portfolios – strategies for addressing a powerful bias – providing insights to help enhance the value of your advice.
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1 Markman, Art. “Why Hearing Good News or Bad News First Really Matters,” Psychology Today, June 2014.
2 Nobel Prize winning research, by psychologists Daniel Kahneman and Amos Tversky, 1979, 1992.
3 Baumeister, Bratslavsky, “Bad is stronger than good”, Review of General Psychology, 2001.