Part X in our Wealth Psychology series: University of Toronto Assistant Professor Avni Shah explains that we are wired to feel losses more deeply than equivalent gains, and why that may encourage you to panic when experiencing investment declines.
- We all have a natural aversion to losing money. Imagine this. You're at the mall, looking for a shirt. One is on sale for 30% off. You think to yourself, that's a good deal, but I think maybe I'll come back next week. Now, what if the sale was today only? Suddenly you feel pressure to make a decision. What if you lose this deal? That's loss aversion at work.
Humans feel losses more intensely than gains of the same magnitude. That leads us to prefer avoiding losses rather than seeking gains. When it comes to your money, it may play out like this. You turn on the TV one day to see a breaking news headline saying, stocks plunge. Your brain goes into overdrive. You think of those old photos of the Great Depression. You picture yourself destitute, pushing a shopping cart. You call your advisor, and you clearly state that you want your money delivered to your mattress immediately.
It's understandable that we might panic. Our brains are wired to process financial decisions based on time, context, and money. In this case, it's the notion of time that influences our decision making.
We put an extra emphasis on our feelings of losses right now, while diminishing the likelihood that markets may do well later. And while it's important to monitor your investments, if you do it too much, you'll be much more likely to inflate the importance of any given trading day. But if you have a long term plan, it will take these short term blips into account.