How “Loss Aversion” Makes Investing Painful (And Costly)
If you’re “trying not to lose money,” you’re doing it wrong.
In this article, we’ll cover loss aversion — a foundational human fear that underpins many cognitive biases.
Author’s Note: This article is part of my series on investing psychology:
12 Common Mistakes That Can Destroy Your Investing Profits
Learn how successful investors avoid cognitive traps and build a winning mindset.
Loss Aversion — What is it?
Loss aversion is the tendency of investors to find losses much more painful than equivalent gains are delightful.
Put another way, the pain of losses is much larger than the pleasure of gains.
For example, the pain from losing $100 on an investment is much greater than the happiness from gaining $100 on an investment.
Some researchers suggest investors experience losses as TWICE as painful as gains are delightful.
How does loss aversion apply to investing?
Loss aversion drives some investors to subconsciously prioritize one strategy above all else: Don’t lose money.
Because it hurts so much to lose money, investors make decisions that actually hurt their profits over the long-term. For example:
- Holding onto a losing stock for too long, hoping it will come back up.
- Investing in extremely low-risk assets that are known to provide poor returns (or even negative returns, after considering inflation).
- Quickly selling a stock that has barely increased in price to safely lock in a gain.
Loss aversion comes in many forms and underpins many investing biases.
Another example of loss aversion is investors who are constantly terrified of a stock market crash. Every time the market wobbles they panic and start pulling out money.
I call this the stock market crash “bogeyman.”
No doubt, crashes are awful and can be devastating to your wealth.
But making fear-driven decisions, such as jumping in and out of the market to avoid a crash, is almost guaranteed to destroy your long-term profits.
Another interesting example of loss aversion is when people who know nothing about the stock market say things like, “I don’t invest in stocks because I don’t want to lose money.”
They are driven by the fear of losing money, rather than an ocean of data that shows:
- Since 1926, the stock market has never had a 15-year stretch where it didn’t make money.
- Over time, the stock market tends to return an average of 7–10% per year.
- Money sitting in cash or a low-interest bank account is actively losing value to inflation (recently at a rate of roughly 2% per year).
The rational decision is to invest savings in some type of investment that keeps pace or outpaces the wealth-eroding effects of inflation. But because some people are so averse to the pain of occasional losses, they’d rather sit on the sidelines and guarantee their money shrinks in value.
What should you do instead?
The key to outsmarting loss aversion is to simply ask yourself:
“Is this the best possible decision I can make given the data I have available today? Or, is this decision being influenced by a fear of losing money?”
Another key question to ask is:
“Across my entire portfolio, over long periods of time, will this strategy result in the best possible overall returns?”
That should help you overcome the pain that comes from occasional losses in areas of your portfolio.
And remember, losing money on some stocks and during some stretches of time is an unavoidable part of stock market investing.
It will take some time and practice, but soon you’ll start to spot decisions that are driven by logic vs. decisions that are driven by fear.
Disclaimer: This article is provided for informational or educational purposes only and is not any form of individualized advice. All information is obtained from sources believed to be reliable but cannot be guaranteed for accuracy or completeness. Use this information at your own risk.