Risk Aversion Vs. Loss Aversion - How They Shape Investment Decisions in Different But Related Ways

Investing isn’t just about numbers, but also about psychology. Two common biases, risk aversion and loss aversion, often drive investment decisions and can lead to panic selling during a market crash or investing only in low-risk and low-return avenues.

Recognising these tendencies may help investors make balanced decisions and avoid emotional pitfalls.

Table of contents

• What is risk aversion?
• What is loss aversion?
• Key distinctions between risk and loss aversion
• How investors display these biases
• Impact on investment decisions in stocks and mutual funds
• What investors could do- balanced decision-making

What is risk aversion?

Being cautious is the main goal of risk aversion. Many of us have the natural tendency to stay within what feels “safe” and steer clear of uncertainty. For instance, a risk-averse investor may choose to put their money in government bonds or bank fixed deposits, which might provide consistent, predictable returns, even if doing so means forgoing the possibility of larger potential gains over time by investing in riskier assets.

If all your portfolio is in conservative investments, your money may struggle to outpace inflation over time, which could hold back your long-term wealth building potential. Thus, avoid risk may be a risk in itself. it’s about finding a balance between relative stability and long-term growth potential.

Read Also: Risk Profile: Meaning, Types, Importance and Examples

What is loss aversion?

When the pain of losing is much greater than the joy of receiving an equivalent gain, it is known as loss aversion. This is a common bias that quietly shapes the way many people invest. To avoid a loss on paper, someone may, for instance, hang onto a declining stock in the hope that it will rise again. Alternatively, they may sell a well-performing investment too soon, not because it’s suitable time, but because they don't want to potentially lose the realised gains.

Loss aversion might impair judgment. Instead of acting logically, investors may often act emotionally, making unsuitable decisions based on their commitment to a bad investment or leaving the market at an inappropriate time. It's not about being reckless, rather it’s about how our minds often treat losses as more painful than missed potential opportunities.

Key distinctions between risk and loss aversion

• Nature- Risk aversion may translate to preferring potentially low-risk options, while loss aversion means the pain of losses outweighs the pleasure of potential gains.
• Behaviour- Investors who are risk averse might steer clear of high volatility assets completely. Even though they may take some chances, loss-averse investors may often panic sell during a downturn because they react strongly to unfavourable outcomes.
• Impact- Excessive risk aversion may lead to under-investing in growth assets, thus missing out on potential long-term gains. Loss aversion may lead to poor timing––selling performing investments too soon and holding under-performers too long.

Read Also: Loss Aversion vs Logic in Investing Decisions

How investors display these biases

Many Indian investors may have a strong inclination toward risk aversion. A conservative approach to investing is often the result of a strong preference for stability and “guaranteed” returns. Growth oriented assets such as stocks, are therefore frequently underrepresented in many individual portfolios.

Conversely, during times of market volatility, loss aversion is more apparent. Some investors may pause or withdraw their investments in an effort to prevent further losses as a result of anxiety triggered by even brief fluctuations. These emotionally-driven decisions might disrupt disciplined financial planning and, over time, may reduce the potential of long-term wealth creation.

Impact on investment decisions in stocks and mutual funds

These kinds of biases tend to drive people's investment decisions. For instance, a risk averse individual might avoid stocks altogether or might prefer a potentially low-risk debt fund. This may provide relative stability but will also result in the investor forgoing the potential long-term returns that equity investing could provide.

Conversely, a loss averse investor may be willing to take potential risks but may have an extreme reaction when things are starting to turn downward. In other words, they might buy high and sell low, panic sell their money after a decline, and only reinvest when markets have recovered. These sentiment-driven choices might significantly affect the potential for wealth building over time.

What investors could do- balanced decision-making

• Acknowledge biases - It is advised to recognise these impulses in yourself. Awareness might help you be mindful and make rational choices as opposed to emotional ones.
• Follow the plan - By adhering to your investment plan, you might stay focused on long-term goals instead of reacting to short-term market fluctuations.
• Do not panic during a downturn - It is recommended to avoid panic moves when markets fall.
• Seek advice - Consulting a financial adviser might help to avoid letting your emotions cloud your judgment. Expert guidance may provide objectivity and discipline.

Read Also: What are the types of risk in investing?

Conclusion

Thinking about how you respond to risk aversion and loss aversion may be a valuable consideration as part of your investing experience. Risk aversion may take you completely out of the market, while loss aversion may prompt you to act emotionally in a negative market environment. In both cases, they might influence your long-term financial well-being. By understanding your behaviour and staying committed to your goals, you might feel confident with the positives and negatives of investing.

At Bajaj Finserv AMC, we recognise that emotions are the cornerstone of investor behaviour – not just for investors but for investment professionals too. That’s why, behavioural finance is at the heart of our investment philosophy, InQuBe, which combines the Information Edge, Quantitative Edge and Behavioural Edge. By understanding, tracking and monitoring market sentiments and our own investment biases, we seek to make mindful and strategic investment decisions. Get the Behavioural edge by investing with Bajaj Finserv AMC. Read more about InQuBe here.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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