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Risk Aversion vs. Loss Aversion

July 23, 2012
Jonathan Clements, Director of Financial Education, Citi Personal Wealth Management

Investors are often described as risk averse, meaning they favor certificates of deposit, high-quality bonds and other more conservative investments. Yet many of us aren't really risk averse. Rather, we are loss averse--meaning we hate losing money--and that can sometimes prompt us to take on more risk.

Thanks to our strong distaste for losing money, we tend to shy away from stocks, even though the stock market has historically outperformed other investments over time. What happens if we overcome this reluctance, buy stocks and those shares then plunge in value? If our loss aversion is really high, we might panic and sell.

Many of us will tough it out, however, because we hate to sell at a loss and admit we made a mistake. Indeed, we would rather sell our winners than our losers. To be sure, selling winners may sometimes be the right investment decision. But it can also trigger capital-gains taxes. By contrast, selling losers can generate capital losses that can then be used to offset realized capital gains and up to $3,000 in ordinary income each year, based on 2012's tax rules.

But tax considerations are often forgotten amid our emotional response to the market's turmoil. As long as we hang onto a losing stock, we can think of it as just a "paper loss" and there's always a chance the shares may bounce back. In fact, in an effort to make back our losses as quickly as possible, we might even double down, increasing our portfolio's risk by buying more of the losing investment.

And what happens if the investment does indeed bounce back? Many of us rush to sell. This is the old "get even, then get out" syndrome. We have finally got back to even--or close enough--and we are anxious to sell before the shares plunge again.

For more from Jonathan Clements, click here.

INVESTMENT PRODUCTS: NOT FDIC INSURED • NO BANK GUARANTEE • MAY LOSE VALUE

The investment strategies presented are not appropriate or suitable for every investor, and there is no guarantee that these strategies will succeed. Each investor should review with their advisor the terms, conditions and risks involved with specific strategies. The appropriateness of a particular investment will depend upon an investor's individual circumstances and objectives. This information is intended to illustrate products and services available through Citigroup Global Markets Inc. The strategies do not necessarily represent the experience of other clients, nor do they indicate future performance. Investment results may vary. Past performance is not a guarantee of future results.

CDs maturing on or before December 31, 2013, are insured by the FDIC up to $250,000.

Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer's credit rating, or creditworthiness, causes a bond's price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.

Citigroup Inc. and its affiliates do not provide tax or legal advice. To the extent that this material or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Any such taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.

© 2012 Citigroup Inc. Citi Personal Wealth Management is a business of Citigroup Inc., which offers investment products through Citigroup Global Markets Inc. ("CGMI"), member SIPC. CGMI and Citibank, N.A. are affiliated companies under the common control of Citigroup Inc. Citi and Citi with Arc Design are registered service marks of Citigroup Inc. or its affiliates.

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