Another side of loss aversion
They have been seeing the same hairdressers or the same doctors for years. They stick with overpriced energy companies and don't change their mobile providers although they could take advantage of better deals. And for 24 years, they have been going to Lignano in July. Do you know such people? Or are you perhaps even one of them?
“Why change something that has stood the test of time?” you may ask. As we all know, humans are creatures of habit. Psychologists call this phenomenon “status quo bias”. That is to say, people tend to keep the status quo. They repeat past decisions even if the backdrop against which they originally made them has meanwhile changed significantly. This can easily result in bad decisions.
One explanation for the “status quo bias”—apart from laziness—is loss aversion, i.e. our inherent dislike of potential losses. In the previous two installments of this series, I already pointed out that losses annoy people more than equivalent gains please them. Hence, they prefer to keep the status quo, fearing that any changes they make may result in losses, and largely ignoring the fact that they may also gain something.
It is for this reason that those with a “That's how it's always been done!” mentality fall victim to the “status quo bias”, causing them to stick with the mediocrity of what they have rather than trying something new.
This psychological distortion can also be observed when it comes to investing money, as shown by Ameriks/Zeldes in a 2004 empirical analysis. Here's what they found: Investors keep their portfolios that they put together nine years earlier, without assessing whether the portfolios are still attractive at all in the current climate—and despite the fact that they have grown older and their investment horizons are different as a result.
The “status quo bias” was first scientifically described in 1988 by researchers William Samuelson and Richard Zeckhauser, who investigated this phenomenon in a number of experiments. Among other things, they found, during a thought experiment involving subjects, that investors with hypothetically inherited portfolios tended to keep them without making any changes. The experiment also showed: If the subjects had inherited money rather than portfolios, their investment decisions would have been completely different.
From a rational point of view, younger investors who intend to make provisions for their old age would have to change the composition of the portfolios they inherit from their parents. Their investment horizons are longer (as they have more years of their average life expectancy left). Hence, younger investors can take greater risk. This is reflected not only by numerous research papers but also by a frequently used rule of thumb: “100 minus age” equals the proportion of a portfolio that should be invested in a risky manner. In other words: For 30-year-old investors, it makes perfect sense to hold up to 70% of shares in their portfolios. That said, as they grow older, investors should reduce the proportion of risky investments.
When it comes to avoiding this psychological distortion in the context of making investments, I recommend that you do the following: Whether you have inherited your portfolio or whether you have held it for several years, be sure to regularly assess its attractiveness against the backdrop of the current investment climate. Ask yourself if your investment decisions would be any different if you had only money but no securities yet. Make a mental clean sweep and start building your (optimal) portfolio from scratch. Then, gradually restructure your investments until you eventually have your target portfolio. Tackle the problem at source and escape loss aversion by setting off losses against gains and looking at the investment outcome in aggregate terms. This way, you fight the psychological tendency of focusing more on losses than on gains—and, as a result, your decision-making becomes more rational!
This article was published in the Austrian business magazine GEWINN. Read the original article here (in German).