Joseph Goldy, AAMS®
I recently celebrated my 45th birthday. It was still a great time to reflect on life in general and how the first 45 years have gone so far. Of course, being in finance, thoughts also turned to all of the various market events I have witnessed in that period. The tech bubble bursting in 2000, the 9/11 terrorist attacks, the 2008 financial crisis, and now a pandemic. It seems that once-in-a-lifetime black swan events have happened four times and counting in my career as a financial professional.
What struck me as I was considering each of these events and how people reacted to each was that the most successful clients I have worked with displayed the ability to overcome the behavioral push and pulls of investing. Staying the course during uncertain times is no easy feat because it is difficult to withstand primary human emotion when it comes to investing. Those who do often are rewarded with better long-term performance and satisfaction, knowing they didn’t follow the herd, which can be detrimental to achieving your investment plan.
In that vein, I thought it would be beneficial to highlight some common behavioral challenges with the hope that you may begin to recognize them and avoid making mistakes with your plan that you may later regret.
The field of behavioral finance is a fascinating one. It is the study of investor behavior and how emotions can cause rational human beings, to make inferior choices with their investments. Daniel Kahneman was awarded the Nobel Memorial Prize in Economic Sciences in 2002 when he brought together the fields of economics and psychology. Since then, it has only continued to gain in importance in the financial services field.
What is Loss Aversion?
Loss aversion in behavioral finance simply refers to the fact that people generally try to avoid losses rather than achieve gains. A study done in 1979 by Kahneman and Tversky found that people “feel” losses at roughly 2.5 times higher than when they feel gains of the same amount.
So why do we care? The excessive impact losses can have on investor behavior often causes people never to sell a losing investment. People who are experiencing loss aversion are willing to wait seemingly forever to recover from a loss. It will impact their ability to cut free a losing investment to redeploy capital in a potentially better opportunity.
Likewise, without the discipline of following a defined investment strategy, investors experiencing loss aversion will not likely have the fortitude to rebalance their portfolios as that requires additional buying and selling to bring the portfolio’s risk level back to where it should be. Loss aversion is one of the most widespread detrimental emotions I see when working with clients. Yet, recognizing it and talking it through with people is often all it takes to overcome.
Loss aversion requires an investor to admit a mistake, which is never easy. However, by following an actual long-term investment strategy and working with an investment professional, you will hopefully avoid making this common mistake and the damage it can do to reaching your long-term goals.
Author Bio
Joseph Goldy, CFP®, is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ at Highland Financial Advisors, LLC, a fee-only fiduciary wealth advisory firm based in Wayne, New Jersey.
Joe specializes in working with newly independent women because of divorce or losing a spouse. He understands firsthand the value of having a clear financial picture pre- and post-divorce and a plan to restate goals as a single person. When he is not helping clients, Joe enjoys spending time with his two sons outdoors and volunteering to help raise money for Type 1 diabetes organizations.