When it comes to saving and investing, loss aversion is very much at work in a lot of people’s portfolios. We all know that savings, current accounts and even term deposits hardly give us any yield, yet a lot of people just keep their hard earned money in these accounts.
Why? Because of the possibility of losing money in stock investments. Even if studies show that shares provide the highest returns in the long-term and that all of us have to prepare for our retirement (a long-term goal), the loss aversion is so powerful in the decision making that most people are willing to take the more certain risk of eroding the purchasing power of their savings.
A recent study looked at 2 options promoting gain or loss
The participants were given $100
First option was
- Keep $60 or
- Gamble the whole amount with a 50/50 chance of losing all or retaining $100.
Second option was
- Lose $40 or
- Gamble the whole amount with a 50/50 chance of losing all or retaining $100.
The results were quite interesting. In option 1, 43% of people chose to gamble, whereas in option 2, 61% of people chose to gamble. Both options had the same outcome.
What it suggested was that people would gamble against a loss but were less likely to gamble on a gain.
If you had $100,000 today and after 5 years its value was $90,392 would you consider that to be a good investment?
Most sane people would say no! However, that is what people are doing today, holding money in bank deposits, where they are getting 0% on deposits and inflation is 2%.
The psychology of seeing a potential short term loss is overriding common sense.
Getting a real return of 1% (cpi +1%) your value after 5 years would be $105,101.
