Most people feel the pain of losing more strongly than the joy of gaining. This higher sensitivity to losses is nothing but loss aversion bias. Studies show that people react twice more strongly to loss than profit. To elaborate, a loss of Rs. 50,000 feels more painful than the gain of Rs.1 lakh.
Many investors invest only in safe products due to the fear of loss. Other examples of loss aversion bias are - an investor selling his investments at a marginal profit fearing correction in markets and an investor holding on to a weak stock hoping that its price will go up.
Loss aversion bias causes investors to invest in less risky assets making them miss out on potentially rewarding opportunities. Such investors generate sub-optimal returns from their portfolio. Additionally, over long term, the purchasing power of these investors decreases due to real rate of returns.
As an advisor, you would have come across many clients who suffer from loss aversion bias. Here is how you can help them overcome it.
Share past data to help clients understand that volatility does not always translate into loss.
Many clients associate risk with volatility. They feel that certain asset classes like equity are very risky owing to the frequent rise and fall in the market. Suresh Sadagopan of Ladders7 Financial Advisories counters this notion by using historical data. “We have built model portfolios for different risk profiles. Using historical data as evidence, these portfolios demonstrate the relation between past performance and volatility. This helps calm their jittery nerves,” says Suresh.
Gradually introduce riskier investments in your client’s portfolio
Depending on the risk appetite of the client, you can slowly introduce riskier investments in the client’s portfolio. To start with, debt funds would be the first step for a risk averse investor. Once he gets comfortable with debt funds, you can gradually introduce equity portion in his portfolio through balanced funds. Finally, you can recommend pure equity funds to him.
Educate your client on opportunity cost
If a client is holding on to a loss making investment, help him understand the real cost incurred in staying put. Help him understand that blocking funds in a loss making security means the money does not generate returns elsewhere. Thus, he is missing an earning opportunity. You can ask him if he would invest in the security again. If the answer is no, ask him the reason for holding on to it. This will give him better perspective on his investments.
Sticking to the financial plan
Benis Kumar Moses, Partner and Behaviour Architect at FinalMile Consulting believes that it is difficult to be calm and take rational decisions during ‘hot’ markets. “Awareness of a bias does not help your clients avoid it when markets are rallying. To prevent the bias from interfering with investment decisions, you need to build a robust investment plan, which accounts for all the biases. The next step is to ensure that your clients stick to the financial plan in unstable markets. Develop this plan in relatively benign markets and stick to it when markets turn volatile,” he added.