Updated: May 15, 2023
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What is loss aversion?
Loss aversion is a cognitive bias that describes the tendency for people to feel the pain of losses more intensely than the pleasure of gains. In other words, we tend to be more sensitive to losses than we are to gains of the same magnitude.
And this can lead us to make decisions that are overly cautious or risk-averse, which can negatively impact our ability to achieve our financial goals.
To better understand how loss aversion works, let’s consider a simple example. Imagine that you have a choice between two scenarios:
We’ll flip a coin. If you win, I’ll give you P1,000 but if you lose, you get nothing.
I give you P1,000 and we’ll flip a coin. If you win, you keep the P1,000 but if you lose, you give back the P1,000 to me.
Most people would choose Scenario A, even though the end result and probabilities of both scenarios are the same.
This is because in Scenario B, the pain of giving me back the P1,000 feels painful. Hawak mo na, pero nawala pa. So you’d rather choose Scenario A where if you lose, nothing happens.
Loss aversion is a common reason why people don’t invest. They are afraid of losing money even if the risk is manageable and the potential reward is greater.
How to avoid loss aversion
Now that we understand what loss aversion is and how it works, let’s talk about some strategies for dealing with it.
1. Set clear goals and stick to a plan.
One of the best ways to overcome loss aversion is to have a clear set of goals and a plan for achieving them. This can help you stay focused on the big picture and avoid making impulsive decisions based on short-term losses.
2. Diversify your investments.
Diversification can help reduce the impact of individual losses on your overall portfolio. By spreading your investments across a variety of asset classes and sectors, you can minimize the impact of any single loss.
3. Take a long-term view.
Loss aversion can cause us to focus too much on short-term losses and miss out on long-term gains. By taking a long-term view and focusing on the overall trend of your investments, you can avoid making decisions based on short-term fluctuations.
4. Focus on the upside.
Finally, it’s important to remember that investing involves risk, but it also involves the potential for significant gains. By focusing on the potential upside of your investments, you can help counteract the negative impact of loss aversion.
Loss aversion is a common psychological bias that can negatively impact our ability to make sound investment decisions.
By understanding what loss aversion is, how it works, and how to deal with it, we can become better investors and achieve our financial goals. Remember to set clear goals, diversify your investments, take a long-term view, and focus on the potential upside.
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