If you ever kept a gym membership long after it has become clear that you are not now and will never be a gym rat, then you have felt the effects of loss aversion. This particular effect of behavioral economics explains why people are more likely to work to avoid a loss than they are to earn a gain. Loss aversion is the wiring that makes us feel more depressed at the loss of $100 than elated at winning the same amount of money. No, it’s not rational, but it does affect how you handle your money.
The Retail Effect
For example, ever wonder why retail clothing stores have those helpful bags and baskets for gathering all your potential purchases? Retailers know that once you have held an item in your hand, you’re psychologically tied to it and you don’t want to give the item up. The longer you have it in your possession, the stronger that connection, and the more you are unwilling to part with your new stuff.
Loss Aversion in the Stock Market
You will also see this effect very often in the stock market. Investors will hold onto a tanking stock long after it is clear that the investment is dead in the water, because loss aversion makes it difficult to let go in fear that it might recover. This is also the reason why people keep bread machines, treadmills and their college stereos around the house, as they hate to think of selling it at a loss. Even though it’s worth more to you if you sell it for $5 at a yard sale, the perceived loss is a killer.
Avoiding Loss Aversion
Loss aversion is so deeply written into our psyches that it is extremely difficult to avoid, even though it is possible to watch others make irrational decisions based on loss aversion. In order to combat the effect, it’s necessary to do a rational cost/benefit analysis of nearly every financial decision, which is difficult to say the least. However, there are a few things you can do to combat loss aversion in various settings:
When you are out shopping, avoid picking up any items you don’t really want to buy. It’s much easier to leave the cute purse or new gadget behind if you’ve never thought of it as “mine!”
When you’re offered a free trial period of anything, like HBO with your cable package for example, just say no if it’s not something you’re currently willing to pay for. The cable company knows you will be willing to pay more in three months to keep your fix going than you are to just buy it outright. That’s why they offer the trial.
In terms of investments, automation of a sensible strategy will help to combat your loss aversion. If you are not involved in the intimate details of each purchase and sale of a stock, you’re less likely to feel so psychologically tied to a particular decision.
Make Loss Aversion Work For You
Luckily, loss aversion can be a powerful tool for self-improvement, if you recognize how to use it. Just as you don’t want to lose money, you don’t want to break a streak, either. If you post a large calendar in your home and place a gold star or red X on every day that you do something you’re working toward, compose 500 words of the novel you’ve been meaning to write, refrain from smoking, exercise, etc, loss aversion will keep you working on that streak once you have a decent chain of days going. Your disappointment in seeing a day without a gold star is greater than your happiness at any single day’s work. So use that psychological trick to keep you on track.
Next week, we’ll examine why it is so difficult for our brains to understand just how unlikely it is to win the lottery.