Who was Daniel Kahneman and why is his idea of “loss aversion” so important?

In 2022, Daniel Kahneman was awarded the Nobel Memorial Prize in Economic Sciences.

A psychologist and behavioural scientist, Kahneman made his name studying cognitive biases – particularly those around money – and “hedonic psychology”, the economics of happiness.

It was thanks to this work that Kahneman received the award more commonly known as the Nobel prize in Economics – all despite claiming to have never taken an economics course throughout his long and illustrious career.

Kahneman sadly died in March, but there can be no doubt that his ideas will continue to influence behavioural psychology, especially those around wealth. His expansive work and research into the psychological side of money management in particular have led to him being referred to as the “grandfather of behavioural economics”.

His identification of a concept known as “loss aversion” has been especially impactful. This cognitive bias affects many more of us than we might realise, and it’s important to be aware of it so that you can prevent it from influencing your financial decision-making.

So, find out what loss aversion is, why it matters, and how working with a financial planner can help you avoid its impact on your wealth.

Loss aversion involves being more averse to losses than the potential of gains

Kahneman developed the theory of loss aversion alongside fellow psychologist Amos Tversky.

The central thesis of loss aversion is that we feel the pain of losses twice as intensely as the pleasure of gains. As a result, we’re predisposed to avoiding losses, even if it means passing up on potential gains.

Consider this example: would you rather have a 100% chance of receiving £10, or a 50% chance of being given £100?

Although you could receive a larger amount by taking on some risk, the theory of loss aversion posits that we’re more likely to take the guaranteed £10. The pain of potentially receiving no money leads us to take the lower amount, forgoing the opportunity of greater returns.

To use an old adage: a bird in the hand is worth two in the bush.

It’s easy to allow loss aversion to stop you from making sensible financial decisions

In isolation, loss aversion may not seem all that bad – it arguably promotes a cautious approach to money that could serve you well. It might prevent you from making reckless decisions with your wealth and help you build your savings slowly and responsibly over time.

But, being prone to this bias could actually have far-reaching – and potentially negative – consequences.

Having seen the hypothetical example above, let’s now consider what this might look like in practice.

A common financial decision you might have to make is whether to save or invest your wealth. Saving is generally the lower-risk option because your money isn’t exposed to market volatility, receiving interest to slowly grow in value.

Meanwhile, investing your wealth in various assets inherently carries risk, and you may get back less than you invest. In return for this risk, your potential for greater returns is typically higher.

If you were to take a loss-averse approach, you would most likely choose to save your money. That way, you could be confident that your wealth is safe from market fluctuations and you won’t lose value on it.

Yet, this ignores the fact that investing can generate greater returns than cash in the long term, even when taking market volatility into account.

Indeed, this is exactly what long-term data from the Barclays Equity-Gilt Study shows. This research looked at returns from UK equities, gilts, and cash over the period from 1899 to 2022, and found that the probability of equities outperforming cash was:

• 70% over two years
• 91% over 10 years.

While past performance does not guarantee future performance, this means that investing is logically the more sensible move for building long-term wealth as it is likely to outperform your cash savings.

However, if loss aversion gets in the way, you may stick to cash, even though it could mean lower returns.

Working with a financial planner can help you manage your wealth effectively

As you can see, overcoming loss aversion may be necessary to ensure that you can make the most effective decisions with your wealth. Otherwise, you may end up generating smaller returns on your wealth for fear of ever losing out.

If you think that you’re falling victim to loss aversion, this is where a financial planner can add immense value in three distinct ways.

1. Investing in line with your capacity for risk

Firstly, they’ll consider your individual tolerance and capacity for risk. While we can all be affected by loss aversion, some people are more comfortable with risk than others.

You might accept that volatility is a natural part of investing and are used to seeing the value of your wealth fluctuate. Furthermore, your level of wealth may mean you have a greater capacity for risk as you’re better placed to be able to afford losses.

Or, this may make you more anxious and you’d prefer to avoid risk. Meanwhile, your capacity for risk could be smaller as a result of your financial circumstances.

Wherever you fall on this scale, a financial planner can take this into account when investing your wealth. They can recommend suitable investments for you in line with your tolerance and capacity for risk, ensuring that you’re comfortable with your exposure to loss.

2. Helping you cope during market dips

Additionally, a planner can be hugely valuable when markets fall in value.

Volatility is inevitable when investing, and it’s highly likely that at some point, you will see some of your investments dip in value when markets fall. At this time, it can be highly tempting to sell your investments at a lower price in an attempt to cut your losses. This feeling can be especially potent if you’re prone to loss aversion.

Yet, when markets fall in value, this is often temporary and your investments could recover their value given enough time. Indeed, figures from CNBC assessing the S&P 500 Total Return Index in the US show that the market’s worst days have historically been followed by its best days.

All this to say, it could be a mistake to react and sell your investments when they have fallen in value because of a market dip.

A financial planner can help you cope during these moments, offering support and guidance when markets fall and encouraging you to remain invested during a period of temporary volatility. This behavioural coaching is just as important as your tolerance for risk, as making sensible decisions while investing is key to successfully growing your wealth.

3. Using your goals to design a suitable investment strategy

Finally, and perhaps most importantly, a planner will consider your personal goals and aspirations when investing your wealth. This is crucial because it means they can deliberately target what you need to achieve your desired lifestyle, rather than seeking to generate the greatest returns possible.

That way, the level of risk you adopt is specifically tailored to help you reach your targets. Knowing that your wealth is organised in this way could make it easier to accept the short-term losses you may see, safe in the knowledge that you’ll remain on track towards your goals.

So, if you think you may be affected by the bias of loss aversion, a planner could help put your mind at ease.

Get in touch

If you’d like help managing your wealth so you can avoid common biases and make more informed decisions, please do get in touch with us at Britannic Place.

Email info@britannicplace.co.uk or call 01905 419890 to speak to an experienced financial planner.

Please note

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

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.