“Sometimes it’s best to cut your losses and move on.” I remember reading this in management textbooks in college, and it seems like a cliché that is echoed in all the current management literature. While this is easy to say and to advise others to do, it is not easy to do ourselves, and it is not easy for our clients to do. The following client experience illustrates this point.
In the summer of 2007, we encouraged a client to draw approximately $500,000 out of her nonqualified investment portfolio to pay off the mortgages on several of her rental properties. We showed her that this would increase her discretionary cash flow and strengthen her balance sheet while not changing her net worth. She listened carefully to our presentation and then said she was not going to make the changes. She went on to explain that as long as her nonqualified investment portfolio was at or above a certain level, she felt like she would not have to go back to work. If she made the changes we recommended, it would drop below that level. She then admitted that if we made the same presentation to one of her legal clients sitting next to her (she’s an attorney) and the client reacted the same way she did, her comment would be, “Get over yourself. This makes sense. Do it.” However, our client could not say the same thing to herself.
In this case, the client was completely aware that she was having an emotional reaction that was preventing her from making a sound logical decision. What she did not understand—nor did we at the time—is that the emotion she was experiencing is called “loss aversion.” Even though her cash flow would improve more than enough to meet her needs, she perceived a loss of freedom if the value of her investment portfolio dropped below some arbitrary number.
Sometimes loss aversion can blind a client to opportunity losses. How many times have you heard a client say something like, “I bought that stock for $30 per share. It has been trading in the mid-20s for the past eight years, and I’m convinced that it was a bad decision. As soon as it gets back to $30, I’m going to sell it”? Of course, the time period makes a significant difference, but most likely the client would have experienced some gain if that stock had been sold as soon as the client felt it was a bad investment and then reinvested the funds in a better choice.
We see in these illustrations that loss aversion makes it very difficult to “cut your losses and move on,” no matter whether those losses are perceived or real. Yet there are times when the management textbook advice is best followed. So how can we overcome loss aversion when we see it?
It is worth pointing out that loss aversion is hardwired. It is very hard to overcome, and it may be providing valuable information that should help inform a decision. It is always best to use facts and logic to test the validity of emotional reactions before rejecting those emotions completely.
Definition And Neurobiology
Loss aversion refers to the tendency of people to more strongly prefer avoiding losses to acquiring gains. In fact, several studies have shown that the emotional pain of a loss is two times greater than the emotional enjoyment of an equivalent gain. Loss aversion was first demonstrated by Amos Tversky and Daniel Kahneman (in the report Prospect Theory: An Analysis of a Decision Under Risk, published in 1979.) “Prospect theory” was a decision-making model that challenged the “expected utility” theory often taught in economic courses.
The psychology of loss aversion has been widely studied and applied to fields like behavioral finance, and we are beginning to understand the neurobiology of loss aversion. A broad set of brain areas is activated in response to gains, including the ventromedial prefrontal cortex (associated with decision-making and learning in the context of reward and punishment), and the ventral striatum (associated with learning, motivation and reward), according to Camelia Kuhnen and Brian Knutson in their article “The Neural Basis Of Financial Risk Taking” in the journal Neuron. Interestingly, the activity of the same areas decreases with losses. Some of the activated areas contain dopamine neurons and are known to be activated in response to pleasure.
The sensitivity to losses disappears in individuals with damaged amygdalae (part of the limbic system activated when we experience fear). Other studies have shown that the amygdalae are involved in decision making. Knowing that the amygdalae are involved gives us an important clue about how we may deal with loss aversion.
To understand why we may be wired this way, we need to understand that our brains evolved to deal with a different environment from the one we live in. Resources were scarce. If, as a caveman, you owned one axe, obtaining a second did not double your chances of success. Losing your one axe could mean death. There are other cases where our wiring does not serve us well. Our fight-or-flight response was designed to deal with predators that could kill us. It is now activated to some degree by the million stresses of modern life. And there is a disconnect between what we should fear and what we actually fear. You are 15,000 times more likely to die of heart disease than die being struck by lightning. Which do you fear most?
Techniques To Address Loss Aversion
In order to effectively manage our loss aversion, we should remember that it is based in these fears. Any thinking that comes out of our limbic system happens very quickly and mostly unconsciously. If we can engage our clients’ slower, conscious thought processes instead, we may have success in helping them manage loss aversion.