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MANY OF US SUFFER from so-called loss aversion: We get more pain from losses than pleasure from gains. In other words, we’d rather not lose $5 than find $5 we never had.
Loss aversion has been extensively studied in financial decision-making. But it also applies to sports—especially golf. For instance, tournament coordinators might change a hole from a short par 5 to a long par 4. Par measures the number of strokes a golfer is expected to take to complete the hole—and, if they don’t, they “lose” relative to par.
When par is reduced by one stroke, the hole itself doesn’t change one bit. Still, one study found that this has a psychological effect on even the world’s best players.
When a hole was labeled a long par 4, golfers were more aggressive in trying to finish the hole in four shots and avoid losing a stroke relative to par. By contrast, when the hole was deemed a short par 5, golfers didn’t push themselves as hard, because they knew they had five shots to make par. Result? Over four rounds of a tournament, this more conservative approach resulted in players recording one extra stroke, on average. In golf, that’s often the gap between first and second place.
For the golfers in the study, their loss aversion helped them play better. But for investors, loss aversion can be detrimental to their success—because they’re so fearful of realizing investment losses. How can you protect yourself from this behavioral mistake? Consider three steps:
1. Separate your money into buckets. Your money for short-term, intermediate and long-term goals should be invested in different ways. By separating your money into different accounts for their respective goals, you can also temper your loss aversion. How so? You’re less likely to become unnerved—and perhaps panic and sell—when your long-term money experiences short-term losses, because you know your short-term finances are safe.
2. See the silver lining. Investors are so anxious to avoid realizing losses that they’ll hold on to losing stocks longer than those that have gone up in value. Whether you call it optimism or stubbornness, it’s a behavioral tick to be avoided. While you wouldn’t want to bail out of stocks generally if the broad market declined, there’s no guarantee that any one individual company will recover. Got an individual stock in your taxable account that’s in trouble? Try to look beyond the money lost—perhaps by thinking about the tax savings if you sell your loser and use the capital loss to offset other winners.
3. Take the overnight test. This is a trick I learned from Carl Richards, The Sketch Guy of New York Times fame. Suppose you own an individual stock that’s fallen in value and you know you ought to sell. Perhaps you hold it in a retirement account, so there’s no tax loss to be had.
Try imagining you went to bed one night and woke up the next morning to find the stock had been replaced by cash. Now, you have the option to buy the stock back at the same price—or reinvest the cash in some other way. What would you do? Changing the perspective can help you make the right decision.
Ross Menke is a Certified Financial Planner. He strives to provide clear and concise advice, so his clients can achieve their life goals. Ross’s previous articles include Not Toast, Cash Is King and More to Come. Follow Ross on Twitter @RossVMenke.
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Great article. This point: “Try imagining …the stock had been replaced by cash. Now, you have the option to buy the stock back at the same price…What would you do?” reminds me of a rule I heard a long time ago: If a stock goes down, only sell the stock if the underlying reason you bought it in the first place has changed. But to your point: if the underlying reason you bought the stock HAS changed, sell it immediately.