What is Loss Aversion, and Why does it make it hard to save and invest.

Put yourself in this situation: You’re staring at two doors. If you go through the door on the left you’ll find $100 on the table, and a man who flips a coin, and if heads, puts another $100 on the table. If you go through the door on the right, you’ll find $200 on the table and another man who flips a coin. If the coin is tails, he takes $100 off the table. Which room would you choose?

You might realize that it doesn’t actually matter, each room has an equal probability of giving you either $100 or $200 dollars, but your primitive animal brain thinks differently. To your animal brain, it does matter. When a similar experiment was run with capuchin monkeys, they preferred the door on the left. The reason is a concept called “loss aversion”. Basically, we feel the pain from losing $100 more strongly than we feel the pleasure of gaining $100 from windfall.

What does this mean for the aspiring investor? It can be tough watching money, that you worked hard for, being stuffed away for a future that’s hard to imagine. Compared to the very real experience of spending it now, that you have to give up or “lose” to invest.

How your perception of time can affect your eagerness to save and invest.

Humans perceive time in two ways: in reference to a clock and psychologically. The psychological view of time is how your brain looks at past events, and future expectations. If you don’t have a solid view of the future in your psychological perception of time, to your brain, it’s as if the future doesn’t exist. If the future doesn’t exist, then putting away money “for the future” is seen as a loss at the expense of spending that money on happiness now. If you have vague goals, or worse, no goals at all, your brain has a hard time treating the future as something that will eventually be here. So what little pleasure you might have felt from investing money might disappear entirely as you feel that investing is putting away money for nothing.

If you can focus on the kind of future you want, and imagine the amount of money you’ll need. Run some compound interest calculations (I like using 7% as an inflation adjusted long term average) and see what your future balance could look like and your future monthly income. The more you imagine it, the more your brain makes it real. The more your brain sees the future as a real thing that’s coming, the more it will care when your actions might put that future in jeopardy.

If you want to learn more about how your brain perceives time, I recommend reading out The Time Paradox by Philip Zimbardo and‎ John Boyd Ph.D.

Humans are more emotional than rational, which makes for bad decisions in a down market.

Sometimes the market dips… Like it may or may not be doing at the time of writing. Now the data, and advice from experts on what to do is absolutely clear. Hold. Stick to your plan (Unless your plan was not made to handle risk, then a dip might be a good wake up call to build a little more risk tolerance into your investing strategy.) Being in for the long haul pays off, even if you were The Worst Market Timer In History. But it’s hard to do. Your balance feels so real when you look at it, that when the market takes a turn downward it feels like somebody is robbing you blind. You want to make it stop. Take your money out and put it into stuff. Stuff that doesn’t just disappear or get smaller from time to time. It’s important to remember you actually haven’t lost anything until you sell. If you let your emotions decide to only put money in when the market is doing well (prices are up) and sell whent it goes down, then you’re buying high and selling low, the exact opposite of what we’re suposed to be doing.

How to cope with and overcome loss aversion and time perception

The best way to avoid making a bad decision, is to remove the need to make any decision. If you can set up automatic deposits into your investment account (an amount that your budget allows for), then you won’t have to worry about feeling the urge sacrifice your future financial security for a baller Ducati.

If your employer offers a tax sheltered retirement contributions make sure to contribute the amount required to receive the full employer match. This is part of your salary, and you don’t want to leave it on the table.

Pay Yourself First: Make it a priority budget item. Do not invest what you have left at the end of the month. Spend what’s left after paying yourself. Remember that the key to accruing wealth is this: A part of all you earn is yours to keep, and money that is yours, can and should work for you.

Actionable Advice

  • Utilize employer retirement programs, at least up to company match.
  • Have some money for savings and/or investing deposited automatically on a regular basis.
  • Don’t check your portfolio constantly! The market goes up and down regularly, but the long term trend is up.