23 May Why We Hate to Lose
Here’s a challenge….
Would you accept a bet based on the flip of a coin? Heads, you win £100. Tails, you lose £100!
If you’re like most people, you’ll say ‘thanks, but no thanks!’
Why? Research has shown that as humans, we have a natural tendency to react differently to gaining and losing the same thing. We’re highly averse to accepting loss. We tend to feel losses twice as strongly as gains. So, in the example above, most people would want £200 or more if the coin comes up heads, to make the risk of losing £100 worth their while.
When it comes to investing, we have a stronger preference to avoid losses over making gains. We tend to focus more on the risk and downside of an investment than the potential gains. This isn’t necessarily always a bad thing. It’s our innate survival instinct to respond more powerfully to threats than we do to opportunity. This is how our caveman brain tries to keep us safe. And this instinct can be helpful in avoiding high risk investments that are potentially ruinous to our finances.
But this natural tendency can also drive us towards harmful decisions, where we seek to avoid losses at any cost.
A recent report shows that Brits keep an estimated £275 billion in cash ISAs, earning little or no interest. This might be a safe place to stash your cash in the short term, but it’s a bad idea in the long run. Given paltry interest on deposits, rising inflation can wreak havoc on the buying power of your money in the long run.
One way to deal with this is to take a more methodical approach to risk and reward. And this is why at Tandem, we go through a thorough process to help clients understand their own risk profile. Clients complete a psychometric risk questionnaire to help them (and us) understand the level of risk they’re willing to take. Then we follow this with a meaningful discussion about their financial objectives. The result is that we can make an intelligent decision about risk, rather than being driven by the caveman tendency to avoid risk at all costs.