How Fear of Loss Can Influence Clients’ Financial Decisions
Explore how the desire to avoid loss can influence how clients make
financial decisions.
People tend to be emotional about loss and try to avoid it. This is also true when it comes to money. You may have experienced this with clients who don’t want to sell an underperforming investment because they fear they will experience regret afterwards. In this article, Victor Ricciardi, author and professor of business explores loss aversion and the effects it can have on financial decision-making, and discusses strategies that can help overcome it.
Definition of Loss Aversion
Loss aversion is the idea that losses generally have a much larger psychological impact than gains of the same size. For example, it’s better to prevent losing $100 than it is to gain $100. Each person has their own unique risk tolerance based on their personal circumstances. This can include things like age, demographics, income, or even the number of years a person has left until retirement.1
The Disposition Effect
The disposition effect is an extension of loss aversion bias. It relates to the tendency to sell investments that have gone up in value too early and to hold onto investments that have dropped in value for too long. This happens when investors don’t want to admit a mistake or are unwilling to experience the actual emotional loss. Some investors may feel driven to sell profitable investments too soon yet they may be more inclined to hold on to losing investments with the hope that they may still generate a profit.2
Regret
Regret, in this context, is a negative emotional response to a financial decision that has an unfavorable outcome, such as selling an investment at a loss. When losing money, regret can amplify both loss aversion and the disposition effect.
For example, if a client previously experienced regret over the purchase or sale of a financial product, it can make them reluctant to look at the same type of investment again. Regret aversion can sometimes lead investors to make poor investment decisions based on their regret about previous decisions.3 Some people can also experience regret if a product they previously purchased becomes available at a lower price or if a product’s value increases after being sold.
Some clients may hesitate to purchase a financial product that may help their retirement portfolio, such as an an annuity, because they place greater significance on the costs than the potential benefits. An annuity may provide clients with the substantial benefit of a guaranteed income for life, but some people may prefer not to risk a loss in liquidity because of using their retirement savings to make the purchase.
Managing Loss Aversion, the Disposition Effect, and Regret
Focus on the positive
One way that you can help clients mitigate loss aversion is to frame client conversations in a way that highlights potential benefits rather than focusing on the risks. Consider building clients’ confidence through education by explaining how financial products can provide a solution to their needs. For instance, having some guaranteed income and an element of protection could help guard against potential losses that may be experienced by higher risk investments.
Use mental accounting
Mental accounting, in this context, is a client’s tendency to divide their money into buckets rather than looking at it as a single pool. This is helpful if, for example, a client has buckets for short-, medium-, and long-term money. Not only can this reduce the urge to sell at the wrong time, but it can help ensure that investors have the right long-term products in place to help safeguard the day-to-day costs associated with the rest of their portfolio.
Helping clients shift their perspective can take time, patience, and commitment. In order to help them understand their preconceptions and promote a more balanced approach to decision-making, it’s vital to start by building strong, long-term relationships with clients based on trust.
1 Loss Aversion: Definition, Risks in Trading, and How to Minimize. Investopedia, June 27, 2022.
2 Why do we tend to hold on to losing investments? The Decision Lab, as of December 2023.
3 Effect of Regret Aversion and Information Cascade on Investment Decisions in the Real Estate Sector. Frontiers in Psychology, October 29, 2021.
Victor Ricciardi was paid a fee to prepare this article. The opinions expressed by Victor Ricciardi do not necessarily reflect the opinions of Brighthouse Financial. The author is not affiliated with Brighthouse Financial, is not an employee or representative of Brighthouse Financial, and is solely responsible for the content of his presentation. While this information is from sources believed to be reliable, the accuracy cannot be guaranteed.