- 3-Minute Article
- Aug 28, 2017
How Fear of Loss Can Influence Clients’ Financial Decisions
Professor Victor Ricciardi explores how the desire to avoid loss can influence how clients make financial decisions.
People tend to be emotional about loss and to try and avoid it, and this is equally 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, I look at loss aversion and related tendencies, and discuss strategies for overcoming them.
Loss aversion is:
- The tendency to place greater significance on losses than gains, to the extent of preferring to avoid a loss than make an equivalent gain.
- Put simply, a $40 loss on the downside has the same emotional impact as a $20 profit on the upside.
- Research has found that people tend to become more risk averse to losses as they get older.1
For example, a client may find it difficult to purchase a financial product they need for their retirement, such as an annuity, because they place greater significance on the costs than the benefits. An annuity may provide them with the substantial benefit of a guaranteed income for life, but they prefer not to risk any loss or regret they may feel from using their retirement savings to purchase one.
THE DISPOSITION EFFECT
The disposition effect is:
- 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 do not want to admit a mistake or are unwilling to experience the actual emotional loss.
- The disposition effect is an extension of the loss aversion concept.
For example, a client may hold on to underperforming investments in their portfolio rather than literally cut their losses and move their money to a less risky or better performing product.2
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 is closely associated with amplifying both loss aversion and the disposition effect.
For example, if a client has experienced regret before over the purchase or sale of a financial product, it can make them reluctant to look at the same type of investment again. Regret may also be experienced if a purchased product later becomes available at a better price, or if a product rises in value after being sold.3
MANAGING LOSS AVERSION, THE DISPOSITION EFFECT AND REGRET
Focus on the positive. Research shows that personality traits such as optimism and confidence can help overcome the loss aversion response, while worry or pessimism tends to make it stronger.4 Consider building clients’ confidence through education, focusing on how products provide positive solutions to their needs, for example, by providing a guaranteed income and protection against potential losses from higher risk investments.
Use mental accounting. In my article How to help your clients make more rational financial decisions, I discuss mental accounting, which, in this context, is a client’s tendency to divide their money into buckets rather than look at it as a single pool. This is helpful if, for example, your client has buckets for short, medium, and long-term money. Not only can this moderate the urge to sell at the wrong time, but it can ensure your client has the right long-term products in place to ensure their day-to-day costs are covered in the rest of their portfolio.
Improving your clients’ decision making takes time, patience and commitment. If you want to help them understand their preconceptions and promote a more balanced approach to decision making, it is vital to start by building strong, long-term relationships with your clients based on trust.