Yesterday on my way to work, I was tuned into NPR’s Morning Edition and I overheard a story about two researchers using our natural instinct to avoid losses as a motivation to lose weight.
The concept is called loss aversion and is summarized by Wikipedia as such:
[L]oss aversion refers to the tendency for people strongly to prefer avoiding losses than acquiring gains. Some studies suggest that losses are twice as powerful, psychologically, as gains.
Quite often loss aversion is a very dangerous thing when it comes to personal finance and investing. Loss aversion is the explanation for why people get nervous and want to sell stocks when their value is dropping, even if they have good reasons for owning those stocks and it’s a great long-term investment. You have to fight against your natural tendencies to succeed as an investor.
But can this natural tendency be helpful? Here are some ways where loss aversion can actually help with your finances.
Recognize it I realize now that the biggest thing keeping me on my insane schedule of the last two years was loss aversion. I was so afraid of losing something that I threw everything I had at juggling a lot of balls. It was only after some careful reflection that I began to see that I was doing all of this out of an aversion to loss – and that aversion was keeping me from really succeeding. I was so scared of failing at all of these things that often I wasn’t trying with my whole heart to succeed, just to not fail. Once I realized that, it became a lot easier to look at my life and see what was most valuable to me: my children and my family and writing, and I made the powerful decision to leave a “safe” job to really become a better parent and a better writer.
Set goals The more detailed and specific your goal is, and the more attainable it is especially in the short term, the more of a “loss” you feel when you don’t achieve it. Here’s an example: wake up in the morning and pledge to yourself that you won’t spend any unnecessary money today. Put a little card noting that pledge on your pillow. That night, when you see the pledge, you’ll either (a) feel success at your first step or (b) feel a big swoon for having failed this little goal. Eventually, you’ll start becoming averse to that loss of positive feeling – and when you know that the actual route to avoiding that loss is simple, you’ll start doing it.
Use a big carrot Tell your wife that if you guys together can bank $10,000 this year, you’ll spend $4,000 of it and take the family to Disneyworld (or some other prize). You’ll both work towards that goal quite intensely, finding ways to save money and invest it well. The aversion to “losing” that vacation becomes a motivator, and having someone else work with you towards the goal will help, too.
Invest more conservatively If you find the swoons of the stock market make you sick and trigger those “loss aversion” feelings, causing you to make bad investment decisions, consider investing more conservatively. Put your money into bonds that will steadily earn over time. You might want to even keep things in cash in a high-yield savings account. This isn’t a “losing” route, as many people will tell you – it’s a losing route to buy stocks and then sell them when the market goes down and your loss aversion is going crazy. A steady 5% or 6% return, year in and year out, with no worries, is not a poor choice, especially if you’re prone to loss aversion.
In short, knowing that people have a natural loss aversion and recognizing it when it happens is the real key to maximizing that feature of human psychology for yourself.