5 Keys to Dealing with Loss Aversion
Editor’s Note: Gary recorded this video a few weeks ago before the recent downturn in the markets. But the message is as relevant as ever.
- Behavioral finance shows that we feel the pain of a loss twice as strongly as we enjoy the thrill of a gain.
- If you’re retired or unemployed, make sure you have three to five years of ready cash at all times to cover your expenses.
- You also need a clear path and plan, a long-term portfolio, a relationship with a trusted advisor, and the ability to engage in slow versus fast thinking.
*** The book Thinking, Fast and Slow can help you with loss aversion and critical thinking.
Back when I started in this business, our firm’s founder, Ed Coyle, used to joke that investors expect 20 percent annual return on their money, fully guaranteed by the government, fully liquid, with no taxes. We laughed because it’s not achievable. Everything seems wonderful for investors when markets are calm like they are right now, but sooner or later the tide will turn, and investors will be in the grips of what behavior finance experts call “loss aversion.”
Daniel Kahneman, Nobel laureate and author of the 2011 book Thinking, Fast and Slow, argues that losses are twice as devastating to us psychologically as gains are joyful. So, here are five keys to preventing loss aversion before the recession or down market hits:
- Design and implement a clear path and plan. The path is all about the environment around us. When bad times occur, you’re inundated with discouraging news and there are lots of negative influences around us. It’s critical to have a very clear path for your financial future to ensure use stick to your long-term plan and remain level-headed.
- Structure ready cash flow. Make sure you have three to five years of cash flow available if you’re not working, in order to cover your expenses. This allows the long-term stuff to recover through the next down market cycle.
- Design and implement a long-term portfolio. There are two main factors against us: inflation and taxes. We have to have long-term investments so we can continue to grow our nest egg and have more income in the future.
- Establish a relationship with a qualified, trusted advisor. Whether it’s with an accountant, attorney, wealth manager or financial planner, you want someone you can call or meet with on short notice when things get rough financially. They act in your best interests and will walk you through these difficult times.
- Employ slow thinking. As Kahneman describes in his book, there are two systems for thinking: System One, which is fast thinking, and System Two, which is slow thinking. The majority of time we make decisions very quickly—it’s a necessity of modern work and life. Slow thinking, however, really makes us pause, remove emotion from the equation and take the time to analyze a situation carefully so we can come up with a good decision.
Keep these five principles in mind to avoid loss aversion. And please share this post with a friend or loved one if you think they’re dealing with loss aversion.
Until next time, enjoy.
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