Have you ever shopped for flights on EasyJet (or any other discount airline) and had this message pop up?
Aww, isn’t that nice of old SleazyJet? I better book those tickets now before they run out! I don’t want my next holiday leading me down the path to financial ruin!
Having successfully averted that disaster, you turn to Amazon to order some diapers for your toddler. It must be your lucky day because next thing you know you see this:
Who wouldn’t want to have those nappies at your door before you run out – for free! Sign me up, Bezos!
Miraculously, plowing through your to-do list leaves you with some much-needed life energy for a decision that really matters. You know, like consolidating your pension pots.
You decide to go with Hargreaves Lansdown and next thing you know, they send you this:
Just what is going on here? Has the whole world conspired to give you a BETTER deal today?
Now don’t get me wrong. I will always choose EasyJet over Ryanair. I have been an Amazon Prime subscriber for longer than I can remember. And Hargreaves Lansdown is my favourite place to consolidate workplace pension pots.
Yet the reality is that all of the messages above are nothing but marketing gimmicks. They are designed to take advantage of a fundamental personality trait we all carry.
It’s probably costing you thousands of pounds in forgone wealth every single year. And you will keep losing money – unless you take the time to recognize and address this fundamental decision-making deficiency we all have.
Understanding Loss Aversion
The textbook definition of loss aversion is people’s tendency to prefer avoiding a loss to acquiring an equivalent gain, usually by a factor of two.
For example, if you were to lose £50, the emotional pain you’d feel would be twice as intense as the pleasure you’d get from finding £50.
And if someone were to offer you a favourable coin toss, you’d want the odds to be at least twice in your favour before you would accept.
If you miss out on a chance to buy “cheap” EasyJet tickets before they run out – you lose. If you already “have” an Amazon Prime membership and then let it expire – you lose.
And sure as hell you won’t let that cashback offer from Hargreaves get away, not if you can help it!
Why Me? I Haven’t Done Anything To Deserve It!
As with most behavioural bias, the reason we suffer from loss aversion is evolutionary.
Humans as a species have been around for over 200,000 years. For the vast majority of that time, survival and procreation were the raison d’etre for every single day of our predecessors’ lives.
Making it through the day was considered a success. Trying to get a drink of water from the nearest river and ending up in crocodile’s jaws – not so much.
Better to go to sleep thirsty than not to make it at all.
As a result of living lives where losing often had catastrophic consequences, our brains have become wired in a way where losses absolutely terrify us. And it will take more than a few hundred years of modern life to wipe out a fundamental trait honed over millennia.
Put another way, we all like to win but we HATE to lose.
And this is precisely why we are so open to manipulation.
Loss Aversion And Financial Independence
As I am sure you have figured out by now, loss aversion can lead to many stupid suboptimal decisions. Viewed through the prism of financial independence, they can be categorized into two buckets:
- Making decisions that lead to spending more money unnecessarily
- Making decisions that lead us to making less money than we can
Let me give you a few more real-life examples of how loss aversion could well be sabotaging your path to FI:
- Leaving a significant chunk of your money in cash accounts and having its value wiped out by inflation (see item #4 on this list)
- Not selling an investment that has lost you money even if it’s the right thing to do – because you don’t want to crystallize a loss
- Selling a stock because it has made you money – because you want to lock in the gains and avoid a “loss”
- Not accepting what is objectively a good price for your house (or any other asset) – simply because it’s lower than the price you paid for it
- Not firing your financial advisor – because you admit it was a mistake to hire him in the first place
- Not asking for a promotion or a raise – because what if they say no?!?
- Not changing a job you dislike – because what if the new one is even worse?
- Falling prey to any kind of “LIMITED TIME ONLY”, “DON’T MISS OUT”, “LIMITED QUANTITY REMAINING” or trial period marketing – unless it’s objectively a good deal on a product that you would have bought anyway
- Most importantly – keeping up with the Joneses! Because if Dave next door buys a new Tesla and you don’t, that kind of means you lost out…
I am probably not going to win a Nobel Prize for saying that all of the things above are bad for anyone’s journey to financial independence (even though this guy did).
But even if we recognize our own fallibility, what is one to do when the devious marketing industry lays its deathly trap for us yet again?
As it turns out, there is an effective way to mitigate your natural tendency to avoid losses.
Tackling Loss Aversion With The Overnight Test
The only effective way to overcome a behavioural bias is to separate emotion from decision. And one of the best ways to do that is to let someone else make the decision.
Imagine you were scared of asking for that raise. Then you took a holiday and while you were gone, someone else asked for the raise on your behalf. Would you approach your manager and withdraw the request?
How about if you went to sleep and when you woke up, you realized someone else fired your financial advisor? Would you call him and hire him again the following morning?
Or take that stock that’s been losing you money over the past three years. The one you really know you shouldn’t own yet never “got around” to selling. You log into your investment account and guess what – someone sold it on your behalf. Are you going to be in a rush to hit the “buy” button again?
All of the above are examples of an overnight test. It places an emotional buffer of sorts between you and the decision, giving us some mental space to step back and evaluate a decision on its merits as opposed to letting the marketing industry take advantage of our monkey brain.
As it turns out, sometimes this is all we need to start making better decisions.
Don’t get me wrong – you won’t change the wiring in your brain. No one will ever want to “be a loser”, whatever that means in our society. But if you acknowledge your imperfect decision-making and hack it with the overnight test, your future self (and finances) are bound to thank you.
Note: I’m proud to say that as a result of researching and writing this article, I finally got rid of two index funds (EWZ and EWW) that never should have been in my portfolio in the first place. And that is what Banker on FIRE is all about.
Have a great day everyone. And if you have examples of successfully tackling loss aversion, please share them below.
About Banker On Fire
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Banker On FIRE is a London-based M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
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