How to Use Loss Aversion to Your Advantage

How to Use Loss Aversion to Your Advantage

Financial loss is often talked about as something that can be avoided by people who are “good with money.” But losing money in the stock market will happen to all of us, and pretending otherwise, or worse—jumping from investment to investment to try to mitigate losses—can leave you with a mess on your hands. It’s part of doing business in the stock market, and coming to accept downturns is part of being a mature financial investor. We all need to consider both loss and risk when making financial decisions and learn to use them as tools that help us prepare for the future, not as topics that we shy away from out of fear or shame.

Listen to this week’s episode of RICH & Regular about the fear of losing money and continue reading below to learn how to evaluate risk in your life to reduce financial loss. 

Know the difference between risk and loss.

Human beings are hard-wired to avoid loss as much as possible. Evolutionarily speaking, this makes sense because loss usually meant something life-threatening like a lack of food or running from predators. Unfortunately, our brains still send us these danger signals, even when (or maybe especially when) we’re looking at our bank balances or investment portfolios.

A field of behavioral economics is called loss aversion, and according to investopedia, it is “the observation that human beings experience losses asymmetrically more severely than equivalent gains. This overwhelming fear of loss can cause investors to behave irrationally and make bad decisions, such as holding onto a stock for too long or too little time.” 

Human beings tend to weigh our fear of potential loss heavier than any potential gains we might experience. If we take a deep breath and look at loss from an intellectual standpoint, we can use loss aversion to our advantage when we are preparing to take a risk instead of reacting emotionally.

Evaluate the risk to mitigate loss.

How do we use risk management to help us mitigate future losses? Prepare ahead of time. How you approach both risk and loss is deeply personal. Knowing how we are likely to react when the threat of loss appears allows us to use this to our advantage and take calculated risks.

Think ahead.

Reflect on times that unexpected challenges appeared. How did you react? Did you try to pull in and protect what was yours—a modern-day circling of the metaphorical wagons? Or did you take a deep breath and lean into the uncomfortable?

Statistically speaking, most of us tend to panic and race to keep what we have, sometimes to the detriment of potential gains. Still, we can train ourselves to evaluate risk in a healthier, less emotional manner. Start with these tips.

Know who you’re working with.

Investment forums and brokerage offices are full of buyer beware stories of people who didn’t do their homework and trusted the wrong person. Do your research on any opportunity that comes your way before you hand over funds or sign anything.

Also, consider the person or group that is asking you to invest. What is their past track record? Are they known for being calm and calculating, or do they react emotionally and panic when problems loom? Knowing who you’re doing business with can be just as important as evaluating the opportunity itself.

Visualize potential issues ahead of time.

Everyone makes mistakes, including the professionals. Reduce the potential fallout from them by brainstorming as many potential problems you can think of, from the catastrophic down to the mildly inconvenient, and ask yourself, how bad would this be? If your answer involves being financially ruined or otherwise losing more than you’re comfortable with, talk with your brokerage advisor and adjust your plan accordingly.

Set checkpoints to help you evaluate.

When you’re considering the potential risk of an investment, the payoff might be years or even decades down the road. Developing a list of criteria or milestones to hit and check off along the way can help you measure the investments progress over time and watch for trends. Having this data available lets you compare your investments’ progress during all phases of the market and helps you make a rational decision when things get bumpy.

Develop a circle of experts.

Knowing who to trust can be challenging. The internet is full of people who claim to know how to maximize your investments, and it can be hard to pull real wisdom from all the noise. Research brokerage firms or brokers that you may consider working with using the Broker Check on the Financial Industry Regulatory Authority (FINRA)’s website to confirm your broker’s accreditation and any past disciplinary action taken or documented issues.

It’s also important to make sure that your broker’s values align with your own. Before opening an investment account with them, research not only their fees and returns, but also their customer service reviews, the about page on their website and ask other investors what they have to say about the firm.

Trust your instincts.

It’s important to know ourselves and our risk tolerance to help us evaluate investment opportunities. Sometimes, our gut instinct that something is dangerous is absolutely correct, and you should avoid those situations at all costs. Other times, our fear of possible loss gets in the way of taking a chance that might have a huge payoff. It’s essential to balance listening to your gut with objective evaluation to ensure that your investments are as successful as possible.

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