The date has forever been burned in your memory; the day you lost £150 on your £10,000 investment. But you struggle to remember the exact day you got that £150 back. On the day it surpassed £10,000, you remember being pleased, but you don’t remember when it happened.
If this sounds familiar then you’ve suffered from the symptoms of, what behavioural economists call, loss aversion.
What is loss aversion?
Loss aversion is the tendency for individuals to prefer avoiding losses than acquiring gains. It is thought that the pain of losing is twice as powerful as the pleasure of gaining. Therefore, individuals are more prepared to take risks to avoid a loss than they are to achieve gains.
The higher the risk, the higher the potential gains
Reading this you might wonder how this works. The more risk you take with an investment, the higher the potential gains (and losses). This is the investment rule that we all follow. But by avoiding loss you are taking on some less obvious risks.
The first is inflation risk. By avoiding losses you are, by nature, more likely to save in a cash account. Cash is seemingly safe. In the old world, if you put £10,000 in an account in January the worst case scenario would be £10,000 in December; if you shopped around you might have £10,300.
But that was the old world, the world of competitive interest rates. We’ve had low interest rates for seven years now; they were cut again in August. Some banks are talking about charging for a positive balance in a cash account, whilst others have cut interest rates. Whilst inflation sits at 0.6% the risk isn’t that obvious but the average inflation rate over the last 20 years is over 2% and many experts predict that inflation could hit 3% by the end of the year. Leaving your money in cash could mean that you see the real value of that money diminish over time.
The second risk is concentration risk. By seeking to reduce your risk you are likely to invest in what is familiar. That likely means cash and investments in your own territory, like government bonds. This would lead to a currency concentration – which over the period we’ve just had would have been quite damaging. By exposing yourself to other currencies (and more apparent risk) you shelter yourself from currency drops. The value of sterling dropped by 10% after Brexit; if you had investments in other currencies you will have protected the real value of your money.