People are more likely to invest in less risky securities to minimize the risk of losing money, as well as being less likely to build portfolios to take advantage of opportunities.
This psychology will help your clients make better investment decisions.
Risk Tolerance.
Loss aversion is an emotional bias in which investors do not take risks and consequently miss out on opportunities as well as experience poor investment outcomes over time. Learning to recognize and reduce loss fear are part of financial planning.
What you tolerate risk is a personality feature based on your resources, income and ambitions. Then it depends too on such things as investment horizon and population – if you are retiring in a few years then it might be wise to invest more in stocks – as long as you don’t mind losing money.
However, if your goal of savings is shorter term such as saving up for the down payment on a house within a year, then you’re short-termism won’t work. Also, you should discuss your risk tolerance upfront with an expert in financial planning.
Investment Time Frame.
The investment behavior that the investor dislikes is the risk of loss in place of gains. This bias could lead them to pursue too conservative portfolios with limited growth; missed opportunities and a disinclination to adjust could get in the way of portfolio diversification efforts.
An investor who bought Nikola on a massively overvalued basis and then the share price dropped would find it hard to sell even if it’s in their interest to do so. It is the disposition effect, and sunk cost fallacy, of loss aversion that account for this kind of behaviour.
Getting to grips with the influence of loss aversion can attenuate its negative effects on investing. Education and self-reflection can be used to discover how a bias affects one and work against it, and seeking counsel from an objective advisor or mentor can also prove useful in reviewing earlier decisions made for good or bad results.
Investment Objectives
Design written investment objectives to minimize loss aversion. Your objectives must be specific and long-term, predictable returns are preferable to quick returns, and you need to consider your situation – for example, if you intend to retire within 5 years, you might not be best off going all out on growth assets because their declines may occur around the time you need to cash them out.
People need to stop and reflect on past decisions and ask themselves if loss-aversion shaped them. Learning about biases affecting choices might identify when loss aversion is blinding the judgment; being aware of them will counter it consciously. With a neutral financial advisor, you get an additional perspective and can mitigate the effects of loss aversion.
Behavioral Patterns.
Loss aversion is a bias in the brain that causes behavioural responses to adversely affect investment. These might mean giving up new ventures that are likely to be more lucrative and sticking to conservative tactics instead. Knowledge of cognitive biases and a financial strategy are good weapons in the fight against loss-aversion, making better decisions that align with your risk tolerance, objectives and time-horizon for investing.
A risk averse investor tends to be incredibly fearful when he’s trying to purchase properties — not willing to sell in a red flag that might ultimately yield some profit, open to settling loan rates for more time than needed. Rather, selling the asset before the asset had appreciated was preferable.
Some investors can break the habit by getting advice from neutral parties, using experts for objective feedback, remembering past decisions or doing performance reviews on a regular basis.