Risk Aversion vs. Loss Aversion
By Jonathan Clements, Director of Financial Education, Citi Personal Wealth Management July 23, 2012 12:00 PM
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.
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