Loss aversion
Loss aversion is a protective mechanism in our brain that gets activated when our brains sense fear or danger. For example, the brain senses a fear of losing money and wants to protect you from making a decision that could lead to losing money.
Loss aversion means that once an action is deemed risky by our minds we tend to avoid it, even if the risk is well calculated. Humans are risk averse, especially when it comes to financial decision-making such as taking a trade or investing in an asset. There is a simple example explained in the book “Thinking, fast and slow” by Daniel Kahneman.
People who are offered a bet to flip a coin (50% chance) and can win $2000 when they are right against a loss of $1000 when they are wrong, do not take the bet. They prefer NOT to lose over winning. From a statistical point of view, you should take this bet, but loss aversion could make you decide not to.
Because of loss aversion, humans tend to avoid taking well-calculated risks because the risk of losing hurts more than the chance of winning. In financial decision-making, this means that opportunities are ignored which could, although indirectly, lead to a worsened financial situation.
Loss aversion comes from our cultural backgrounds and (socio)economic status. Our upbringing and the people around us influence us in how we should perceive risk. If you grew up in a family of entrepreneurs you are less likely to suffer from loss aversion because most entrepreneurs understand that taking well-calculated risks is necessary to grow. However, if you are currently in a situation of financial distress you are less likely to take calculated risks because you are more concerned with preserving the money that you have rather than risking it to make more.
The solution to overcoming loss aversion and being able to take well-calculated risks is to apply “framing” and put the situation into perspective. Framing is the process of portraying the situation from a certain angle to strengthen that viewpoint. In order to avoid loss aversion, you want to frame your opportunities from the positive side of the bet. Portray the situation by highlighting the potential. When you say I have a 40% chance to make $1000 of this action and I have a 60% chance of losing only $400, you have framed the proposition as such that it’s more attractive. The odds haven’t changed, but your mind has a weakness to understand.
If you experience moments of loss aversion try framing the situation to highlight the potential. But, always remember to stick to your risk management principles!
Speak to you soon!
Kind regards,
Joost