Making profits or avoiding losses?

By Paul Seligman

Added 18th March 2016

The psychology of risk aversion is the hardest thing for wealth managers to overcome.

Making profits or avoiding losses?

If someone gave you $1,000 and asked you to go double-or-nothing based on the toss of a coin, what would you do? How about if someone instead took $1,000 from your bank account, and offered you a double-or-nothing chance to get it back?

Studies have repeatedly shown that the majority will not gamble in the first instance, but would in the second. Human nature tends towards protecting profits and avoiding losses. In short, we will toss a coin to protect what we have, but we will not toss a coin for the chance to get more – better the devil you know.

Students of behavioural finance call this phenomenon ‘loss aversion’. Clients are very attached to their money, and are likely to react to a 7% loss with far a far greater degree of anger or disappointment than the corresponding degree of happiness should you be able to present a 7% profit.

There has been an immeasurable amount of research on this issue, and it appears to cross cultural and geographic boundaries. It even seems to be present in other species, as a study conducted on capuchin monkeys showed using pieces of apple.

The firm recently had a potential client. He was a young professional who had been in Singapore for a couple of years, during which he had worked hard, economised and successfully saved a decent lump sum. This hard-earned cash was now in the bank, growing at a sub-inflation rate of interest (so for ‘growing’, read ‘shrinking’). For his future financial security, it was vital that he get his money invested – a savings plan, a portfolio of stocks and shares, an insurance policy, anything to get these dollars working for him – but persuading him of this fact proved challenging.

“You’re actually losing money at the moment. Inflation is reducing the value of your cash more quickly than the bank is paying you interest,” I said.

“Yes, but isn’t there a risk that I will lose my money if I invest it?” was the concerned reply.

It is fair and completely understandable that people in this situation worry along these lines in the post-2008 world. My potential client’s adult life has been dogged by terrifying stories of people laid low by the financial crisis. No matter how hard we try to convince people with logic, their natural desire to protect that which they have earned is hard to overcome.

The key is to separate the idea of investment from the risk of ‘losing it all’. In the eyes of many risk-averse clients, investment is a sort of serious version of roulette: if you’re not careful, your hoarded treasure could disappear into the croupier’s box. Clearly, that is not the case. Carefully-regulated systems, like Singapore’s, require investment companies to separate their client’s investments from the company’s own profits. The result is that, even in the highly unlikely event of the company falling apart like a jenga tower at a university party, the investors’ cash is ring-fenced.

Clients must be made to understand that while they may lose a small proportion through poor investments, market forces or sheer bad luck, the vast bulk of their money (as a minimum) will be back with them in the end. This way they can overcome the unproductive phenomenon of loss aversion.


Paul Seligman, Meyado Private Wealth Management, Singapore

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