If you’ve ever supported a sports team or person, you’re probably familiar with the crushing sense of defeat when the results don’t go your way.

Indeed, a study of more than 32,000 football fans by the University of Sussex found that the pain caused by a defeat was more than double the joy of winning.

Unfortunately, this experience isn’t confined to the world of sport. According to the Nobel prize-winning psychologist and economist Daniel Kahneman – who sadly passed away in March – “loss aversion” is hardwired in all of us and it can affect every aspect of our lives.

As a result, many of us are more willing to take steps to avoid a loss than to make a gain.

Read on to learn more about the concept of loss aversion, how it might affect the way you invest, and what you could do to prevent it from throwing your financial plans off course.

“Losses loom larger than gains”

Loss aversion is an important aspect of Prospect Theory, developed by Nobel-winning academic Daniel Kahneman and psychologist Amos Tversky.

In simple terms, it suggests you feel the pain of losses more strongly than the pleasure of gains. Indeed, the research demonstrated that losses are twice as powerful compared to their equivalent gains.

If you look back on the performance of your investment portfolio, do the losses spring to mind more readily than the gains? You might not even notice the gradual gains that build up over time, while a modest drop in the value of your investments may catch your attention.

According to Prospect Theory, this is because “losses loom larger than gains”.

In other words, you might have a natural aversion to loss which could potentially limit your ability to make logical and objective investment decisions.

Loss aversion could skew your perception of risk

A fear of losing money could lead to a biased perception of probabilities and outcomes. As a result, you might tend to favour low-risk options, and this could hamper your investment returns.

Imagine that you hold a significant portion of your wealth in cash savings. It’s low risk, feels safe, and you can access your money whenever you need it.

However, cash funds are likely to lose value in real terms over time due to the effect of inflation. So, by playing it “safe” and focusing on how to avoid loss rather than how you might grow your wealth, you could see the spending power of your savings diminish.

On the other hand, adopting a “riskier” approach by investing some of this wealth might be the key to beating inflation and generating higher returns over time. Read more about how inflation can affect returns.

Combatting your instinctive loss aversion and taking a more objective, data-driven view of risk, could open the door to greater potential returns.

Loss aversion could jeopardise your long-term investment goals

Loss aversion often results in emotion-based investment decisions, which could sway you from your long-term investment strategy.

For example, if there is a downturn in the market and your investments drop in value, you might panic and instinctively decide to sell your assets to avoid or minimise your losses.

And yet, a quick look at how the markets have performed historically reveals a reassuring picture. Despite wars, deep recessions, and political unrest, the global economy has typically recovered in the long term. Holding on to your investments gives them the chance to recover in value as and when markets improve.

What’s more, remaining invested over a longer period could give your money more time to potentially grow, thanks to the powerful effect of compound returns – earning returns on both your original investment and on returns you received previously.

However, combatting loss aversion and resisting the urge to respond emotionally to potential or actual loss, can be tricky. We’re all human after all.

A financial planner can help you build an investment portfolio that balances risk effectively

As you read above, loss aversion could result in an overly risk-averse approach to investing. This could make it harder for you to grow your wealth in line with your goals.

Fortunately, we can help you create a long-term investment strategy based on logic and data – rather than your emotions.

By building an investment portfolio that aligns with your goals and attitude to risk, our financial planners can help you build the financial future you desire.

If you’d like help building a diversified investment portfolio that effectively balances risk, please email us at info@blueskyifas.co.uk or call us on 01189 876655.

Please note

This article is for general information only and does not constitute advice. The information is aimed at retail clients only.

Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.