As many of you will know, I am a massive Liverpool supporter. On Tuesday night, we made an improbable come back against Barcelona, beating them 4-0 to get to the final of the Champions League. We will play Spurs in the final (who themselves came back from 3-0 on aggregate to go through 3-3 on away goals with a 96th minute winner!). While Spurs are a domestic rival, there’s not a big history between the two clubs. But in the past, Liverpool have gotten to semi finals with Manchester United being in the other semi final. A lot of supporters simply dreaded the thought of possibly playing Man United in a final. Not because they were better than us but because the thought of losing to them was greater than the thought of beating them in the final to win the European Cup.
Or for you non football fans; if I ask you to do a puzzle and you do it successfully, I will give you €150. But if you fail, you give me €100. Would you do it? Welcome to loss aversion, where the pain of loss is greater than the joy of gain.
Two different clients both have a target pension fund at retirement of €1,000,000. Joe wants to go for it and sticks all his money in equities. Anne is a more conservative investor and has a balanced portfolio of bonds and stock. Over the years, they put in the same amount of money.
Joe’s portfolio journey is erratic with lots of big highs but with some very bad lows too. In the years before retirement, there is a fantastic bull market where his pension fund gets up to €1,300,000. But in the year before he retires, there is a recession and the value of his fund falls to €1,000,000, right what the plan was.
Anne’s more conservative approach has seen ups and downs along the way too but nowhere near to the same degree as Joe. When the stock market crashes, investors moves to bonds, which helps the value of Anne’s portfolio. As the recession hits before her retirement, the bonds element is protecting her portfolio value and she too hits the target of €1,000,000.
Who is happier? Both have achieved what they set out to achieve and it cost them the same amount of money. But Anne didn’t lose anything that she already had but Joe did. Joe will have regret that he didn’t sell out earlier.
Another area loss aversion has an impact is letting go of what we already have. Working with a lot of retiree’s, downsizing is something that is talked about but it rarely actually happens. People are happy in their bigger homes and it is mentally difficult for them to give it up, even if they don’t need a house that big or can’t afford it. Moving to a smaller property or apartment has a big physiological impact on them.
What aspects of your life does loss aversion impact on? Is is stopping you from making important financial decisions? Let me know by dropping me an email at email@example.com