How to Stop Letting Emotions Control Your Financial Decisions

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If I offer you two investment opportunities - A and B.

• Investment A: A guaranteed return of $3,000.

• Investment B: An 80% chance of earning $4,000 (and a 20% chance of earning nothing).

Which one would you pick?

When given the choice, most people instinctively will choose Investment A - the ‘safe’ bet - with a 100% chance of earning $3,000. This is because of the risk associated with Investment B. However, Investment B has a higher expected return of $3,200 (80%*$4,000).

This psychological bias is called Loss Aversion - the phenomenon that we experience the pain of losing far more intensely than the joy of gaining. In other words, losing $100 feels significantly worse than the joy of gaining $100, even though the financial impact is the same.

Now, let’s flip the initial scenario

Would you rather:

• Lose $3,000 for sure, or

• Have an 80% chance of losing $4,000 (and a 20% chance of losing nothing)?

Real-life experiments have shown that most people opt for the former even though the expected outcome is a greater loss of $3,200.

With loss aversion bias, people tend to be risk-averse in the case of gains and risk-seeking in the case of losses. That is, when making profits, we prefer to take profits sooner instead of taking more risk (risk aversion). However, when we are making losses, because we hate the idea of losing, we prefer to take more risk in the hope that we might recoup the losses (risk-seeking) and this might lead to bigger losses. Loss aversion plays out in many forms. In investing, loss aversion can play out as:

• Holding Losing Investments Too Long. Investors may refuse to sell underperforming stocks or assets, hoping they will "bounce back," instead of cutting losses and reallocating funds to better opportunities.

• Selling Winning Investments Too Early. To lock in gains and avoid potential future losses, investors may sell assets too soon, missing out on long-term growth.

• Avoiding Investments. Some individuals, fearing potential losses, stay out of the market completely, despite the proven long-term benefits of investing.

Loss aversion doesn’t just affect investing—it influences everyday decisions in ways we often don’t realize including:

• Gambling. A gambler who loses money may keep playing to "win it back", even if they exceed their planned limit. Gambling companies are aware of this and often give offers to losers to encourage them to try again.

• Selling a Property. A property owner might refuse to sell for less than the initial price, even if market conditions suggest otherwise.

• Salary Negotiations. Employees might not ask for a raise because they fear the risk of rejection more than they value the potential gain.

• Unused Subscriptions. People keep paying for unused gym memberships because canceling would mean admitting they wasted money. Streaming services and magazine subscriptions rely on loss aversion hence, they make cancelation slightly inconvenient so people keep paying.

• Entrepreneurship. Entrepreneurs may continue pouring money into a failing business instead of cutting losses (sunk cost fallacy). Companies avoid discontinuing unprofitable or unpopular products because they’ve already invested in marketing and production.

How do you overcome this Bias?

💡Acknowledge the Bias. It’s important to recognize that loss aversion is a natural human tendency and you may be prone to it.

💡Adopt a Long-Term Mindset. Recognize that short-term fluctuations are normal, and focus on long-term financial goals. This is especially important when investing in the stock market. Always aim to stay invested for some years.

💡Diversify Your Portfolio. Spreading risk across different asset classes, and geographies, and across different strategies can help mitigate potential losses. You can own index funds and ETFs while simultaneously investing in individual stocks.

💡Set Exit Strategies for Investments. Determining your exit strategies can prevent emotions from influencing decisions. For example, you can decide to sell down a stock if it loses 20%.

💡Reframe Losses as Learning Opportunities. Instead of fearing losses, use them to refine your investment strategy.

💡Automate Your Investments. Scheduling regular transfers to your investment accounts helps remove emotional biases. This way, you are not investing based on your emotions or timing the market.

As humans, we often assume that we are rational people but the truth is that we usually don’t act rationally. While it seems that loss aversion aims to help us avoid losses, it can accidentally drive us into further losses or make us miss out on gains. Hence, it is important for us to carefully observe the choices we are presented with, understand that our response may be driven by how the choices are framed, and be conscious of the many biases we have.

Reflect on This:

• Are you currently holding on to something you shouldn’t because you’re afraid of losses?

Till next week, I am rooting for you, money-ly!

Dee

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Disclaimer: This does not constitute financial advice. Please conduct your research or consult your financial advisor for important financial advice.