“It’s completely natural to try and avoid the burden of a potential loss, especially a financial one. By nature, we are all loss-averse!”
Be aware of your predictably irrational responses and combat them with rational actions
If you felt slightly challenged by the content of my previous three articles, don’t be too hard on yourself. It’s completely natural to try and avoid the burden of a potential loss, especially a financial one. By nature, we are all loss-averse!
This is not to be confused with its very close cousin: risk-aversion.
Loss-aversion implies risk-aversion, but not vice versa.
To put it simply, think of loss-aversion as the fear of flying and risk-aversion as the fear of the plane crashing.
If you’re afraid of flying (loss-averse), it implies that you’re afraid that the plane will crash (risk-averse). But if you’re afraid of being in a plane crash (risk-averse), it doesn’t necessarily mean that you’re afraid of flying (loss-averse). Quite the contrary – I’m happiest if the plane flies from point A to B, with no crashes in between.
I started to really understand the difference between these two aversions after being involved in what I fondly call the worst flight of my life. What was supposed to be a four-hour flight from Rio de Janeiro to Buenos Aires eventually turned out to be a 14-hour journey, which included six ‘free-falls’ (akin to those ‘falling elevator’ rides) with both luggage and people (who didn’t have their safety-belts on, guilty-as-charged) being thrown out of their seats and an emergency landing in Montevideo. All thanks to an electrical storm, apparently.
Am I scared of flying? No … but I sure am scared of crashing!
Another example would be to think of an investor’s perception of equity funds. A loss-averse investor wouldn’t invest in equity, as they wouldn’t even put themselves in the position where they could lose their investment, whereas a risk-averse investor might still invest in equity, but would be nervous of any potential losses (aren’t we all?)
Let’s go back to the start … Loss-aversion, risk-aversion, the list goes on and on with many interesting explanations as to why we behave the way we do in certain situations. No-one likes to hear it, but as humans we all behave irrationally at times. And when it comes to the realm of finances, we behave particularly irrationally. We make mistakes when we invest but more than that, we make mistakes in a predictable fashion.
John Maynard Keynes concurs: “It is hard to see how any rational man can ever invest.”
The key is to be aware of our predictably irrational responses and combat them with rational actions.
How do I manage my fear of being in a plane crash? Two tranquillisers + 1 sleeping tablet = I don’t even realise I’m on the plane!
Gizelle Willows CA(SA)