How Loss Aversion Affects Our Decision Making

If you’ve ever kept a gym membership even though you weren’t ever going, or kept a subscription to Amazon or Netflix even though you weren’t using it, then you have experienced the effects of loss aversion.

Loss aversion is the psychological behavior of perceiving the loss of something as more severe than gaining its equivalent. An example of this would be the feeling of losing $50 being more painful than the joy of gaining $50. One study estimates that the prospect of loss affects life decisions twice as much as equivalent gains (Novemsky & Kahneman, 2005).

The Impacts on Financial Well-Being

Loss aversion impacts our financial well-being, which makes sense because who likes to lose things? We especially don’t like to lose money because it helps us have food, shelter, health, and security. For this reason, investors often hold onto losing investments too long or sell investments too early. Some might hold onto a losing investment with the hopes that the stock will rebound when that is almost never the case.

This also leads to a lot of people investing the bare minimum into their future. It’s human nature to hold on to what we have now. But this is negatively impacting our financial future as well as our present because there’s often a gap between life experience and our expectations. We perceive the amount that we’re holding onto to positively impact our
lifestyle more than it actually is.

A Solution is to Save Slowly

Saving slowly over time has been shown to lower high expectations—to avoid the impacts of loss aversion. Sure, it may seem boring, but a slow and constant flow on savings almost always beats out holding onto money or ‘fast and exciting’ investments. If you want to save steadily and ‘trick’ loss aversion, here are some tips:

Savings Automation

Steadily increase or savings so you won’t be affected by loss aversion by setting up automatic transfers into your savings. This will remove the cognitive effort of transferring money out of your account. In 5 years, that $400 that was automatically transferred into your savings each month will total $24,000.

Pull Savings from Everyday Expenses

You can use the loss aversion to your advantage by calculating your everyday expenses into an annual expense. This can help you realize how much you are spending on things like coffee-to-go, cigarettes, and weekend outings. If it’s $30 on coffee each week, that’s $1,500 annually and $7,500 in 5 years. You might start making your coffee at home and decide to save an extra $1,250 each year.

Think of Your Saving Like a Bill

Think of your savings the same way as your energy bill. It has to be paid no matter what. Once it becomes routine, it won’t be seen as something you’re losing each month. However, instead of losing it to the energy company, you’re paying yourself. By paying your savings account at the same time as your bills, it’ll become consistent.

Use New Technology

With so many free investments applications today, there’s no reason not to take advantage of one or two of them. Many of them track spending habits and even allow you to invest in stocks right on the app. Personal finance apps like TINK, pocketsmith, Tiller, and countabout are a few of them. Some even let you invest in bonds. However, some of those do
charge extra.

Protect Your Savings Account

By all means necessary, protect your savings account. Try to budget correctly so that you don’t have to dip into your savings account for a few hundred dollars every once in a while. Let each one of those savings dollars work for you. Managing your budget is the key to savings.

Need help avoiding the loss aversion effect that affects your financial well-being? Contact IronOak Wealth today to start saving steadily.