Loss aversion and the pain of falling markets

The finding that losses hurt more than equivalent gains please is among the most robust in behavioural research and among the most consequential for investors.

The finding

From prospect theory and subsequent work.

Experimental evidence consistently finds that the psychological impact of a loss is substantially greater than that of a gain of the same size, with commonly cited ratios around two to one.

Which means a portfolio that falls and recovers to the same level has produced a net negative emotional experience despite a neutral financial outcome.

And which explains why investors behave asymmetrically towards gains and losses.

The consequences for investors

Several distinct effects.

Selling during declines, to stop the pain, which crystallises the loss.

The disposition effect: the tendency to sell winners and hold losers, since realising a loss makes it definite while an unrealised loss retains the possibility of recovery.

This has been documented extensively in brokerage records and is generally value-destroying, particularly given tax considerations that frequently favour the opposite.

Excessive caution, holding too much cash and accepting a shortfall risk that is invisible because it produces no dramatic moment.

Reluctance to rebalance into a falling asset class.

And anchoring on purchase price, treating it as significant when it is only relevant for tax.

Myopic loss aversion

Where frequency compounds the problem.

The more frequently a portfolio is evaluated, the more likely any given check shows a loss, since short-period returns are close to a coin flip while long-period returns are more likely positive.

Experimental work has found that investors shown more frequent feedback take less risk and earn lower returns.

Which means checking a portfolio daily produces a fundamentally different experience from checking it annually, with the same underlying investment.

And it produces a practical recommendation: check less often.

Framing

Which changes the response.

The same portfolio described as having fallen twenty per cent, or as having returned to the level of eighteen months ago, produces different reactions.

Expressing changes in currency amounts rather than percentages produces different reactions again — a percentage that sounds tolerable can correspond to an amount that is not, which is why expressing risk in money is a more honest assessment.

Focusing on the total including contributions rather than on the return alone changes the picture for anyone still accumulating.

And measuring against a long-term plan rather than against the recent peak changes it further.

Practical measures

What reduces the damage.

Reduce checking frequency, and remove apps that send price notifications.

Set the evaluation period deliberately — annually rather than continuously.

Write down the plan in advance, including what a substantial decline would look like in money terms and what you will do.

Hold an allocation you could tolerate, which is generally more conservative than a questionnaire suggests.

Automate contributions and rebalancing, so that the decisions are not made during stress.

Hold short-term money in cash, so that a decline never forces a sale.

And expect the discomfort rather than being surprised by it, since anticipated discomfort is more tolerable.

The role of an adviser

Worth mentioning.

A substantial part of what a good adviser provides is preventing clients from acting during declines.

Studies attempting to quantify the value of advice frequently attribute a meaningful proportion to behavioural coaching rather than to investment selection.

Which means paying for advice can be rational for someone who knows they would otherwise sell, and is a different justification from expecting superior returns.

Where loss aversion is useful

For balance.

It discourages excessive risk-taking, which is protective.

It encourages insurance and emergency funds.

And it reflects a real asymmetry in circumstances: for many people, a large loss genuinely does more damage than an equivalent gain does good, particularly near a goal.

Which means the response is not to eliminate it but to prevent it from producing decisions at the worst moment.

The reframe

Which some investors find helps.

A decline in an accumulating portfolio, for someone continuing to contribute, means future contributions buy more.

Which is genuinely favourable for anyone with decades remaining, and which is the opposite of how it feels.

The portfolio value is not the thing being purchased — future income is — and a lower price for that income is not bad news for a buyer.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.