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MP

Guiding the Next Generation of Financial Planners

Loss Aversion

May 26, 2015 Guest User

Think about the following scenario - Your friend will flip a coin. If it is tails, you lose $100. How much do you need to win if it is heads to take the bet?

Most people say somewhere between $180 to $220. In a perfectly logical world, you should accept the bet if heads results in you receiving $100.01; however, this is not the case for most people. This is because the pain caused from a loss is greater than the happiness caused from a gain.

In The Art of Thinking Clearly the author, Rolf Dobelli, writes the following:
Losing $100 costs you a greater amount of happiness than the delight you would feel if I gave you $100. In fact, it has been proven that, emotionally, a loss “weighs” about twice that of a similar gain. Social scientist call this loss aversion.

In the investing world, risk and potential return go hand-in-hand. There is no “limited downside with huge upside” investment. Return is not a possibility without taking risk. Due to loss aversion, each person usually has a slightly different answer to what risk-return tradeoff they can handle. Furthermore, this is effected by risk capacity. That is, the amount of risk one can actually afford to take. (The risk capacity of a single 20 year old with zero debt is much different than the risk capacity of a 40 year old with four infant children regardless of their risk tolerance.)

The best investment strategy is one that is specific to the individual. This has to take into account a person’s individual outlook on the risk-return tradeoff, which will almost certainly be affected by loss aversion. 

In Thought Leadership Tags Joe Markel
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*Communication on this website does not constitute a recommendation and is for educational purposes only. None of the information contained in this website constitutes a recommendation for any specific person. The authors are not advising you personally concerning an investment strategy or other matter. All opinions expressed on this blog are solely those of the authors and are in no way affiliated with any other organization or institution.