By Dr. Rikki Racela, WCI ColumnistAs an avid personal finance teacher and neurologist, I love the blending of these two topics. The interaction of the brain with the world of investing is fascinating, and even more fascinating is this fact: your brain is not designed to help you invest. This brain’s block to successful investing reminds me of the clip from the movie Tin Cup, when sometimes your brain just gets in the way.
One of the largest behavioral finance constructs that has explained a huge bulk of poor investing behaviors is the concept of loss aversion. In this column, we will dive deep into what loss aversion is, the brain areas involved, and how to defeat this formidable investing enemy to attain financial success.
What the Heck Is Loss Aversion?
Behavioral finance has revolutionized the way we understand decision-making in investing, and it was pioneered with the work of psychologists Daniel Kahneman and Amos Tversky in their groundbreaking article, “Prospect Theory: An Analysis of Decision Under Risk,” written in 1979. They found that investors are not rational, where making money is simply a numbers game, risk and reward are quantified, and a person is making the best calculated decision. Rather, prospect theory explains the psychological factors involved in investment decision-making.
One of the foundations of prospect theory is loss aversion, where individuals value potential gains and losses asymmetrically. Losses weigh approximately TWICE as much as gains in their emotional and cognitive responses (the other ramifications of prospect theory are sunk cost fallacy, status quo bias, and the endowment effect . . . but these are for another column). For example, if I were to give you $100 right now, you would probably say, “Sweet, thanks, Rik, you the man.” That would probably be the extent of it, or at the most, you would write a nice comment to this column below. But if I stole $100 from you, your reaction is likely going to be more powerful, including yelling at me, chasing me down, or calling the cops. There might even be physical violence. That’s just a simple example of how you would feel with a monetarily equivalent gain and loss.
But this gets even deeper when you consider this example in Jason Zweig’s must-read book, Your Money and Your Brain:
Yale University researchers trained five capuchin monkeys to trade tokens for snacks like apples, grapes, Jello, etc. Two human researchers would sell these to the monkeys. Seller 1 offered one apple piece for sure and a 50/50 chance of getting a second one. Seller 2 offered two apple pieces at first, and then added a 50/50 chance of losing one of them. The monkeys “traded” a bunch of times, long enough to learn that they would always get at least one apple piece and that the average outcome was identical in either case. Yet the monkeys preferred to deal with Seller 1 71% of the time. Their choice was evidently driven by a desire to avoid the pain of having a reward taken away.
The capuchin behavior suggests that loss aversion existed in our most ancient ancestors and helped them survive. When you think in terms of survival, it makes absolute sense. I can imagine our cavemen and cavewomen ancestors slaughtering an animal for food to feed themselves for the winter, and they would fight to the death to prevent other animals from stealing and losing that food. Whereas if you wanted to gain more food for the winter, you might not risk your life to slaughter that extra tiger for more food. Then, the forces of natural selection would favor the survival of our ancestors whose brains are programmed for loss aversion, rather than to value losses and gains equally. In the book Why Smart People Make Big Money Mistakes by Gary Belsky and Thomas Gilovich, the authors comment, “The tendency to weigh losses more heavily than gains, for example, is doubtless a beneficial trait overall because an organism that cares too much about possible gains and too little about potential losses runs too great a risk of experiencing the kinds of losses that threaten its survival.”
Where to Place the Blame: Brain Structures Involved
There are three main areas involved in the circuitry of loss aversion: the amygdala, the prefrontal cortex, and the insula. These areas of the brain are linked to emotion, motivation, and decision-making, and they are almost always activated in System 1 thinking.
#1 The Amygdala
The amygdala, so named because of its almond shape (almond in Greek is “amygdale”), is located in the depths of the temporal lobe, right next to the hippocampus. It is strongly activated in times of fear and anxiety. Research using fMRI data has shown that the amygdala lights up like the North Star when individuals experience or anticipate losses, and its heightened activity during loss scenarios underscores the emotional intensity that people experience in response to losses vs. gains. The stronger emotional reaction to losses is part of the equation explaining why people are more motivated to avoid losses than to pursue gains of equal value.
#2 The Prefrontal Cortex
The prefrontal cortex (PFC), particularly the ventromedial prefrontal cortex (vmPFC) and orbitofrontal cortex (OFC), is involved in decision-making, impulse control, and evaluating rewards. More specifically, according to Zweig’s book, it plays a role in how we assess potential outcomes of gains and losses vs. the actual outcomes. In the context of loss aversion, the PFC helps weigh the emotional reaction to a loss (processed by the amygdala) against more rational, long-term considerations.
However, in the face of immediate losses, the amygdala’s emotional signals often overpower the more reasoned inputs headed toward the PFC. That leads the PFC to make biased decisions based on all that negative emotion from the amygdala, amplifying the reaction to the fear generated by the amygdala. Basically, it’s garbage in, garbage out. The nearby OFC modulates the perceptions of these negative emotions, given its integral connections to sensory structures of the brain, including taste, smell, and touch. Zweig cites this as why people might say, “I’m so close to making money, I can taste it!” But more deeply, the OFC will amplify negative emotions by pulling in negative perceptions related to our senses. Like the sensation you’re going to vomit when your Bitcoin drops $20,000 in one day. (I’m not judging if this is you and if that $20,000 loss represents only 1% of your portfolio. But if it’s 5% or more, then yes, I am judging you! Please diversify more for the sake of your OFC!) These two substructures within the PFC play a huge role in making loss aversion, well, that much more aversive.
#3 The Insula
The insula, Latin for “island,” is so named because it looks like an island of the brain separate from the rest. You actually have to reflect back much of the neocortex to reveal it (remember that neuroanatomy!). It is heavily activated in response to something disgusting, whether it’s a revolting smell, a bad taste, or an image of people tasting something or doing something disgusting. You know what also triggers this disgust center? The thought of losing money. That’s right, one of the reasons loss aversion is so powerful is that even the brain’s “ewww, that’s disgusting” center is highly activated with the thought of losing money.
Zweig described in one betting experiment that after losing money or choosing a bet where money had been lost, the insula in subjects was 3-4x more active. Zweig himself was subjected to the same experiment, and he described how choosing the bet where he could possibly lose a lot of money made his insula light up like a Christmas tree. He also described the queasy, butterflies-in-his-stomach feeling that came along with his insular activation.
Together, these brain regions explain why loss aversion is such a powerful motivator in decision-making. The emotional centers, including the amygdala and insula, respond strongly to the perceived pain of financial loss, often impeding the other inputs required for rational deliberation that occurs in the prefrontal cortex. This neural interplay is the “System 1” thinking described by Daniel Kahneman that can lead people to make decisions that prioritize avoiding losses over achieving potential gains, hindering optimal investing behavior.
More information here:
Yes, Risk Tolerance Can Be Modified: You Just Have to Rewire Your Brain
Visualizing Your Way to Wealth
How Loss Aversion Affects Investor Behavior
Given our knowledge of the neural circuitry of loss aversion, let’s go through a hypothetical example of how loss aversion works in our brain to make us inferior investors.
Imagine it’s February 20, 2020, and you’ve just finished a shift at the hospital where there is news of a new deadly virus that has already hit the West Coast of the US and it’s spreading. Already freaked out by this information, as now your amygdala is activated because of this virus (known as the disposition effect), you check on VTI to see that the market fell by a few points. You say to yourself, “OK, I know I should stay the course,” but at the same time, your amygdala is more activated after seeing the loss. Luckily, Jack Bogle’s “stay the course” mantra percolates in your PFC and prevents vmPFC and OFC from activating. But another loss comes the next day. Then the next, then the next, then the next. You get a day when the market rebounds, but remember, losses outweigh gains in your mind—and the next day the market tanks again, erasing that good feeling of hope from the day before.
Finally, on March 23, the market hits bottom. Your amygdala is screaming, SCREECHING into your vmPFC and OFC, drowning out the “stay the course” input into your PFC. Bloomberg and CNN are also bombarding your brain with news of the fastest market crash ever and that people are dying by the thousands. Your amygdala is in overdrive communicating with your PFC. Your vmPFC and OFC are now fired up, and your OFC activates your sensory areas, including the insula. You feel nauseous and sick, like you’re going to vomit from a bad taste in your mouth. To make the pain stop, this System 1 mechanism I just described induces your PFC to turn against you. You go to your computer, log in to your brokerage account, and hit the sell button
The above example is an unfortunate and far too common manifestation of loss aversion. Investors freak out when they experience losses in their portfolios and sell off losing positions out of fear of further losses. This behavior can lead to suboptimal—heck, even toxic nuclear—investment outcomes, as they may lock in losses prematurely and miss out on future gains.
Mitigating—and Even Utilizing—the Negative Effects of Loss Aversion
Understanding the effects of loss aversion can help investors make more informed decisions and potentially reduce the negative consequences of this bias. Here are some strategies to mitigate its impact.
#1 Avoid Locking in the Loss
One of the weird quirks of loss aversion is that not only can it result in an investor selling low, but it can also have the opposite effect, where investors don’t sell their losers to prevent locking in a loss. Since the loss is only on paper (or, more accurately, on a computer screen), the loss is not real in their minds. This behavior is detrimental when you are investing in individual securities, but with a low-cost index fund, the chances are that if you don’t sell the fund, it will eventually rise again. Utilize loss aversion to your advantage. Don’t lock in your loss in your index fund.
#2 Reframe the Fear into Greed
You know what System 1 emotion is just as powerful as fear: greed! Investors should strive to view their investments from a long-term perspective and realize that the market goes back up over time. You make millions if you don’t sell. In fact, stocks are on sale during a bear market, and you should buy more! You’ll make millions investing during a bear market. Focus on how rich you’ll be in the long term, firing up your nucleus accumbens, rather than focusing on short-term fluctuations. By doing so, you reduce the emotional impact of the amygdala on your PFC, and instead, the nucleus accumbens activates, keeping you in the game and having you stick to your plan of dollar-cost averaging even during the bear.
#3 Diversify, Diversify, Diversify
Having some Treasuries (preferably short-term, as we saw in 2022) reduces the emotional toll of loss aversion. Also, other asset classes that are not as correlated to equities can be helpful to stay the course, since your losses won’t be as huge. This may push you to stay the course.
#4 Picture the Damage to Your Financial Goals
Think about why you are investing in the first place and picture it. Picture cutting back from clinical work to spend more time with your kids. Think of driving that Porsche (or Tesla) in retirement. Think of the 529 for your cute little kids who will eventually go to Princeton without any worry about hundreds of thousands of dollars of student loan debt. If you sell your equities in a bear market, you are crippling your future self, your spouse, and your kids. If you break, you break your future awesome financial self and those of your loved ones. This should create a different type of loss aversion—the aversion to destroying your financial future and eating Alpo in retirement.
#5 Automate Investment Decisions
As mentioned in David Bach’s The Automatic Millionaire, investors benefit from setting up automated dollar-cost averaging in retirement accounts. It takes the emotion out of decision-making. Ignorance is literally bliss. This strategy helps avoid the temptation to sell during periods of downturns.
#6 Utilize Your Inner X Factor
Jim wrote a post regarding the X Factor, defining it as “that compilation of motivation, willingness to delay gratification, and budgeting skills required to carve out a big chunk of your income to build wealth.” I define it more broadly as the compilation of motivation and willingness to accomplish a difficult goal. You know what you need the X Factor for? Getting into med school! I believe all doctors have the X Factor required to build wealth. What do you think you are trying to prove when you are getting super high GPAs at competitive colleges, passing orgo, and getting a competitive MCAT score? You are proving to med schools you have the X Factor.
Wait, you’re not a doctor? As a reader of this blog, I assume you are a high-income professional, and that also proves you have the X Factor. To get to your station of life, you had to handle adversity in a painful fashion multiple times. You have the X Favor—channel it toward staying invested, just like you did to get into med school or whatever high-income career you attained.
#7 Use Herding to Your Advantage
And not to your disadvantage. Avoid people who are panicking during a bear; instead, come back to the WCI community for a sense of sanity and to take advantage of the bear. We, the WCI community, will stay the course with you. We will help prevent you from throwing away your retirement and compromising your financial life and that of those you love (see #4 above). Karl Marx once said, “Religion is the opium of the people,” and I wrote a college essay supporting that it was herding bias that is responsible for that thesis. Follow the religion of WCI and don’t sell during a bear market.
More information here:
Saving for Your Future Stranger
Wife vs. Husband: A Retirement Account Showdown
Overcoming the Loss Aversion Example
Imagine once again that it’s February 20, 2020, and you’ve just finished a shift at the hospital where there is news of a new deadly virus that has already hit the West Coast of the US and it’s spreading. You are sort of freaked out, but thank goodness there’s no virus in your hospital yet and you’ve noted that the staff is already making preparations. Despite your amygdala being activated, you limit its activation with some optimism. You check on VTI to see that the market fell by a few points. “Awesome!” you say to yourself, “I know I should stay the course, and hopefully it drops further so I can tax-loss harvest.”
At the same time that your amygdala is activated, your nucleus accumbens also offers some input into the prospect of harvesting losses and carrying forward a $3,000 tax deduction each year. Nothing feels better than taking back some money from the government. You also remember your written financial plan that says, “Thou shalt not panic during a bear market or thou shalt hang thyself by thy fingernails.” This activates System 2 and prevents your PFC from activating the vmPFC and OFC. Then, the next day comes a loss. You wait a few days before checking the market on your phone again. You’re busy, right? COVID has now just hit your state. One day you look and eureka! You’ve hit your tax-loss harvesting threshold. You get out of VTI and directly into ITOT, and you get out of VXUS and directly into IXUS.
Finally, on March 23, the market hit its bottom (only in retrospect). Your amygdala is somewhat activated, but it’s not screaming or screeching. Instead, your nucleus accumbens is signaling your PFC much more in comparison. Why do people freak out in bear markets? You freaked out more during the second semester orgo exam when you were trying to draw an aldol condensation on a 50 carbon molecule. That was painful; you thought you were going to fail orgo.
You text one of your WCI doc friends saying, “Dude, isn’t this awesome!” Their response is, “Yeah, it is!” Another friend says, “Yo, I just put in my monthly contribution in taxable. We’ll be driving Porsches in retirement!” You don’t watch the financial porn that is Bloomberg and CNN. Instead, it’s time to invest in taxable. The money in your retirement accounts is already invested, but now you want ETFs for your taxable account. You go to your computer, log in to your brokerage account, and hit the BUY button for ITOT and IXUS. You feel awesome.
The Bottom Line
Loss aversion is a powerful psychological bias that plays a crucial role in maladaptive investor behavior and financial decision-making. By recognizing how this bias affects us and the brain structures involved (amygdala, prefrontal cortex, insula), we can set up defense mechanisms that mitigate or even utilize loss aversion to our investing advantage. Loss aversion is an important irrational human behavior that need not derail us from attaining our long-term financial goals.
Don’t let your brain get in the way.
What do you think about loss aversion? Has it affected the way you invest and caused you to make mistakes? Have you recognized loss aversion in your own investing behavior? How have you overcome this human bias?
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