Your Loss Aversion Is Costing You More Than Your FOMO

By Anum Yoon on 5 April 2017 0 comments

Imagine the following scenario:

You can either pocket a guaranteed $500, or flip a coin. If you get heads, you get $1,000. If you get tails, you get nothing.

Now, imagine this second scenario:

You are given $1,000 — woohoo! But you have to decide whether you'll lose $500 of it outright, or flip a coin. If you get heads, you lose nothing. If you get tails, you lose $750.

Chances are, in scenario one, you chose to pocket the money, whereas in scenario two, you chose to flip the coin.

How did you know that!?

That's because we feel the pain of losing money so much more than we feel the joy of earning a reward. This trend is called "loss aversion," but, in everyday terms, you might find it a bit familiar to FOMO: the fear of missing out.

FOMO tends to describe the pain of seeing your friends on social media doing fun things and achieving their goals while you're left out. In a way, loss aversion is similar because you're afraid to lose out, but the pain might be a bit deeper with money.

It might sound ludicrous that we hurt more when we lose money than we feel joy in earning it. But studies have shown we feel the heartbreak of a financial loss twice as strongly as we feel gaining the same amount of money. So, if you get a $500 bonus from your boss, you'll only be half as emotional as you would be losing that same amount on the stock market.

How might this affect me?

Loss aversion can be both good and bad. For starters, it might lead you to make "safe," low-risk investments. This turns out to be helpful for investments you have to make, such as your retirement fund. Sure, you could put your life savings into a high-risk scheme, potentially multiply it several times over, and retire in riches — but you might also lose it all. It's often better to choose something with a low rate of risk so you have a healthy sum of money to live off one day.

On the opposite side of the coin, loss aversion can cause you to make rash decisions regarding the stocks and investments you hold. For example, if you're an investor in oil-related stocks and have a meltdown every time oil prices drop, you might be inclined to sell off all your stocks and stop the loss as quickly as possible. While this may be a good decision in certain situations, it's always important to remember that what goes down will likely go up again, and holding onto your stock could mean you'll get it back later. (See also: Want Your Investments to Do Better? Stop Watching the News)

Now, that concerns a drop to the market overall. The other potential pitfall of loss aversion is to hold onto stocks that have been underperforming for way too long. Many investors will sell stocks that appear to be at the top of their game, only to find out later that they've continued to grow. Meanwhile, the stocks they're waiting to see flourish continue to underperform, and they lose money in the long run.

How can I avoid falling into this trap?

One of the best ways to make sure you don't feel the pain of loss — or loss aversion — is to diversify your portfolio. In other words, don't put all of your eggs in one basket: Invest in different industries, different types of stocks, and in both short- and long-term investments.

If you're going to make a "risky" investment, make sure you're ready for the challenge. Prepare yourself by building your confidence and learning more about what it means to invest in whatever you're considering. Come up with a fallback plan. You've heard it before, and it's worth repeating: risk equals reward. Yes, you might lose, and that'll hurt — but you might also gain big. If that's worth the leap, then it's time to get off the ground.

If all else fails, talk to a professional about your options. Yes, you might have to throw him or her a bit of money in order to receive financial advice. But having a professional tell you the best, most secure way to invest your money might help ease your mind — and increase your dividends — without breaking the bank or your heart along the way. (See also: The Surprising Truth of Investing: Mediocre Advice Is Best)

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