“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.

The first step is to name the thought process. If a client can say, “I know that it is loss aversion that is influencing my decision-making process,” then they are, in effect, shining a light on the thought process. Just like anything else that people find fearful, when a bright light is shined on it, the amygdala tends to calm down and the fear subsides. Your client will find it easier to engage rational thinking once the fear is reduced.

By naming the thought process, we can also start to evaluate it. This works well under most circumstances. It has shortcomings, but at least when we name a process we can understand why it might fail and learn work-arounds.

When naming fails, we can try to manage loss aversion by “reframing.” The way a problem is presented to us—the way it is framed—will influence the solution we come up with for the problem. Tversky and Kahneman presented the following problem:

“Imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed.”

The first group of participants was presented with the following disease program choices:

• Program A: Two hundred people will be saved.
• Program B: There is a one-third probability that 600 people will be saved, and a two-thirds probability that no people will be saved.
Seventy-two percent of the participants preferred program A and 28% preferred program B.
The second group of participants was presented with the following choices:
• Program C: Four hundred people will die.
• Program D: There is a one-third probability that nobody will die, and a two-thirds probability that 600 people will die.
Seventy-eight percent preferred program D and 22% preferred program C.

Note that programs A and C are identical, except that A is stated in terms of a gain and C is stated in terms of a loss. Programs B and D are also identical. What we see is that when a problem is presented in terms of a gain, people tend to prefer a more certain outcome, but if the problem is presented in terms of a loss, people tend to take more risk.

This suggests that one technique to overcome loss aversion is to reframe the problem from a negative frame of loss to a positive frame of gain. The attorney who did not want to move assets from her portfolio to pay down mortgages saw the reduction in her portfolio as a loss of freedom from working. She framed things using the size of her portfolio. If we had been able to reframe it in terms of her disposable cash flow, showing her that it would improve to the point where her needs were met and she would only be dependent on her investment portfolio in an emergency, she may have been able to “get over herself.”

Those clients who want to hold depreciated stock until it gets back to its original purchase price use as their frame the loss of principal if they sold. If the problem is reframed as a gain of cash that could be used to purchase a more productive and diversified investment, they may be able to sell and move on. For example, you could say to the client, “I know you paid $60,000 for that stock and if you sold it today you would only get $50,000. The goal is to get back to $60,000 as quickly as possible. If you had $50,000 in cash today that you wanted to invest to grow to $60,000 as quickly as is reasonable, would you put it in the stock you currently own?”

We now know how reframing affects the brain. Effective reframing leads to reduced amygdala activity and increases baseline activity in the dorsolateral and ventromedial areas of the prefrontal cortex and the striatum. These areas play very different roles.

First, reframing can make it easier for us to engage our prefrontal cortex—the part of our brain that most recently evolved. It gives us our ability for rational thinking, focus and control over emotions. It has limited capacity, it’s energy hungry and it can be disabled by strong emotions. With this in mind, reframing efforts are best attempted by people in well-rested, stress-free states. Easier said than done, but worth keeping in mind.

Second, one area of the ventral striatum, the nucleus accumbens, is activated when people anticipate monetary gains. After it’s activated, people make riskier choices. In other words, reframing might lead to less risk aversion.

We may think our decisions stem from separate processes, with the amygdala carrying emotions and the prefrontal cortex carrying cognition. This is useful, although assigning a specific function to a specific area is an oversimplification. Networks of areas are involved, and reframing clearly acts at different levels. It doesn’t always work, but it is a powerful tool to move clients in the right direction.

If that fails with a client, other methods known to reduce fear may help (for example, exposing people to small losses to reduce their fear, gradually forming new memories.) Over time, the amygdalae will quiet down. If a client is reluctant to sell a specific stock, perhaps he or she can experiment by selling a small fraction of the total.

The key is for clients to distance themselves from the automatic emotional responses. This requires you to encourage slow, deliberate thinking. Psychology professor Boaz Keysar and his colleagues found an interesting way to achieve this: If you know a second language, make your decision using this language instead of your native tongue. This gives you greater emotional distance and reduces the loss aversion bias. The same process also reduces the degree to which participants in these studies were swayed by the way a decision was framed.

Whatever method we choose, it is important to remember that a rational understanding of the problem alone does not solve it. Even Harry Markowitz, the father of modern portfolio theory, ended up using his emotions when deciding how to invest his retirement money. Financial journalist Jason Zweig once asked him how he manages his investment portfolio. “My intention,” Markowitz explained, “was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.”

Thom Allison, CFP, is the founder of Allison Spielman Advisors in Bellevue, Wash. Andre Golard, Ph.D., is a neuroscientist who offers workshops and coaching on the connection between neuroscience and investing.