Money Mistakes To Avoid – Loss Aversion

July 11, 2007

We covered the first money mistake yesterday and learned not to save with the right hand and spend with the left.  The next mistake the Smart Money magazine article covers is a psychological effect that affects many of us, loss aversion. 

Loss Aversion
I like the way that Wikipedia explains the concept.  Ask yourself this question, “would you rather get a 5% discount, or avoid a 5% surcharge?”  Numerically the end result is the same but people feeling loss aversion are more afraid of a loss than they are motivated by a gain so they choose avoiding the 5% surcharge.  The Wikipedia article mentions some studies that suggest losses are twice as psychologically powerful as gains.

Financial Effects
So what’s an example of loss aversion?  Smart Money uses the case of a penny-pincher who is so fixated on reducing the “loss” of paying too much for gasoline that they’ll drive halfway across town for cheaper gas, burning extra gas and putting more miles on their car.  Loss aversion often creates such irrational behavior where people actually end up spending more money in an effort to avoid  a loss.

Another negative financial effect of loss aversion is the tendency to play it too safe when it comes to investing. Keeping all our money in conservative investments in an effort to avoid loss will erode our net worth in the long run thanks to ever present inflation.  More conservative investments such as bonds are less likely to have huge drops in price like stocks but after their lower returns are gobbled up by inflation the purchasing power of money accumulated over a long time frame is greatly reduced.

Overcoming Loss Aversion
The article suggests that the best way to overcome loss aversion in investing is to take a broad view.  Don’t focus on the immediate effect of your investment but rather look at its long term implications.  Your investments will go down every now and then but it’s okay. You won’t lose any money unless you sell, over time the investments value should have an upward trend. This is easier to do if you put together an investment plan that will help smooth out the highs and lows. The article suggests:

“A well-diversified portfolio should limit the volatility, and some mutual funds, such as asset-allocation and balanced funds, can help keep the ups and downs in check.”

Does loss aversion effect you? Have you ever made an irrational decision to avoid a loss that ended up costing you more money in the long run?

Ben

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Ben

Ben Edwards, the founder of Money Smart Life, saved up enough to buy a Nintendo back when he was 12 years old. When he used the money to buy shares of Wal-Mart stock instead, he knew he wasn’t like the other kids… His addiction to personal finance has paid off for his family and now he’s helping you to afford the life that you want. Check him out on the web at Google Plus, Twitter and Facebook.


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Comments

7 Responses to Money Mistakes To Avoid – Loss Aversion

  • Chris

    I think Independant Thinker missed the point. Loss aversion largely relates to conservative people that aren’t prepared to spend/risk a little now to gain alot later. Infact he sounds like he has the classic case of risk aversion (play it safe and he won’t get burned).

  • Independent Thinker

    I am very smart when it comes to money. My mortgage is less than my house is worth, I don’t tap into my house’s equity; I save 40 percent of my monthly take-home pay (I’m fortunate enough to make a good salary); drive cars until they die and when they do buy used ones for cash; own only two credit cards and never carry a balance. I also pay for groceries, gas, dry cleaning, and other routine expenses with cash. But, no one can convince me that putting my before-tax dollars into the stock market is a good idea. I know that sounds reactionary and “backward” but when all of my colleagues were groaning in October 2008 about the loss of their hard-earned principle, I was actually counting a modest increase in my “investment portfolio” which will earn me a very modest 5% over the next 30 years until retirement. That and the thousands of dollars I save every year from my paychecks will (with due dilligence) be enough. Perhaps more of us should focus on simply holding onto our pay rather than spending so much of it on things we don’t really need like another suit, coat, pair of shoes, or vacation to Disney World.

  • Ben

    Lazy, you’re exactly right. Those unknown default rates are what has kept me away from Prosper.

    I agree Miranda, one thing I have trouble with is car maintenance. I balk whenever the mechanic suggests I do some $150 procedure even though it should help keep the car running and my expenses down in the future.

  • Miranda

    One of the things that I love about my husband is that he has taught me to think in terms of long-ranging decisions. Sometimes what we think costs more now actually costs less in the long run. Sometimes we are so afraid of losing NOW, that we forget that penny pinching can indeed be pound foolish.

  • Lazy Man and Money

    I think this is a huge reason why many people run away from investing on Prosper.com. They fear that they might lose their money if people don’t pay them back.

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