Pain of losing $100 vs. joy of gaining $100 – Which emotion do you think will be stronger?
I would have immediately said it should be the same because, well, the amount is same. Turns out I’m wrong. My actions were totally different when I was faced with this situation in real life.
I was frantically trying to get our 2012 taxes done. I had a week to file the taxes.
First pass at finishing our taxes, using TurboTax: We owed a little more than $5000!!!
I panicked; cried; yelled at my husband for his company’s mistake (their withholding was grossly wrong).
I re-did the taxes a couple more times just to make sure the numbers were right. Yes, they are. We screwed up. I finally gave up and started tallying our accounts to figure out how we were going to come up with this money. The only place we had money was our down payment account. We had the money to pay but that would have meant we had to delay buying our home.
Something clicked in my brain. I gave up the moping and self-pity and got to work.
I collected every single receipt I could find.
I printed out every single statement from all the credit cards we use.
I printed out all our bank statements.
I went through them line by line, categorized and color coded all the line items into medical, office supplies (personal or work related), charitable expenses, etc. Previous years, I had always assumed the medical limit was too high for us to claim anything. This year, I left no leaf unturned. I had to verify if our expenses were really too low to make the deduction. I checked and double checked to see the numbers in my forms (dividend, interest, foreign taxes, etc.) were right.
I tried every possible tax software I could think of TurboTax, TaxAct,…
After 3 days of working more than 16 hrs. a day, I had reduced our liability to the IRS to $2000.
How did $3000 magically get eaten up? No magic. Three things made the difference
- Collecting missed receipts based on my credit card statements.
- Not assuming I won’t be able to take the deduction (we could take the medical deduction after all).
- Some differences in the tax software (I will do a detailed comparison next year as I will also be adding an accountant to the mix).
It was not like I paid less in taxes last year, but as my company withheld more than required and I got back some money, I didn’t put this much effort into maximizing the return. It is so stupid if I think about it. I would have gotten a LOT back if I had done the same thing last year.
So why didn’t I put this effort for reducing my liability and get back as much as possible vs. reducing my liability to not pay at the year end?
I somehow saw the positive return as a windfall and paying year end as losing the money I had.
Of course the economists have a term for it – loss aversion. Loss aversion refers to people’s tendency to strongly prefer avoiding losses to acquiring gains.
Why should you care about a fancy mumbo jumbo term? Because it is preventing us from gaining more wealth.
After realizing my stupidity with our tax return, I wanted to find out what all ways we could have lost money because I prefer not losing what I have more than acquiring more gains.
How can loss aversion prevent us from earning more money?
- Tendency to play it to safe when it comes to investments: For long term growth we need a mix of risky and safe investments. If we think too much about the loss we might incur and stick to only safe investments we lose out on potential growth. Young investors choosing to ignore the stock market as risky make one of the worst decisions possible from a wealth growth perspective.
- Holding on to losing investments for too long: As I have shown above, I do not like to lose money. There are a couple of stocks that I bought when I first started investing (before I learned the magic of index funds) that are pretty worthless now. I no longer invest in individual stocks but I still have them in the hopes that it will be worth at least what I paid for one day. That is a loss I should take right now and invest whatever I get in my balanced portfolio.
In the down housing market, how many people held on to their houses because they hate to sell their house for a loss? How many people spent more money staying put, even if caused them significant financial hardship?
- Junk stays in our house for a lot longer than it deserves: Why do we have the old treadmill, the half broken toaster and the ancient computer in the basement? Because we paid a ton for it and now we can’t stomach the loss. Most of the clutter stays with us because of the loss aversion and sunk cost fallacy.
- Falling for “free trial” and wasting money: Have you ever signed up for a cable package with free HBO for 6 months and then continued to pay for the HBO after the promotion period was over? Even though you never wanted HBO in the first place, now that you have it, you don’t want to lose it. Well, the cable companies know our weakness. Once we have something in our hand, we don’t like losing it. That is why free trials are everywhere in consumer market.
How can we overcome this weakness and make wiser decisions?
Basically we should know when to hold’em and when to fold’em. That is not an easy thing to achieve. So what else can we do to not lose money? The simple way is have a method and stick to it.
- Test your threshold for loss: I do not believe that someone can never feel loss. Every one of us will feel the pain of loss, some more, some less. You are sensitive to losing money more than you think. So instead of kidding ourselves that we are superior to others, it would do us a lot of good to figure out what our pain threshold for loss is. Will it make you lose sleep if you lost 10% of your portfolio? How about 25%? At what point will you be tempted to just sell everything and never get into stock market again?
- Focus on your goals and timeline: In some cases, it is best to avoid losing money. What are you saving for and what is your timeline for needing that money? If you are saving for something that you need in 2 years, of course you will panic if you start losing money from that pot. You can afford some loss in a portfolio with a timeline of 30 years (like retirement). Stick to safe investments if your timeline is less than 5 years.
- Diversity and rebalance: Diversification is one the best things when it comes to investing. It can greatly help in reducing the number of stupid mistakes we make due to our human nature. Do not put everything in one stock or even one kind of investment. Based on your age, risk tolerance and the timeline have a diversified portfolio and rebalance it periodically.
Related post: Busy people’s guide to choosing the best investments
- Have an investment plan and pay less attention to media hype: Once you figure out your risk tolerance and have a financial plan (with goals and timeline) in place, put it on auto pilot. Make use of dollar cost averaging and the periodic rebalancing. Pay less attention to the hype of gloom and doom from the media. I am not saying you should bury your head in sand and ignore everything. Develop a strategy and only take action if your strategy says you should. For example, based on your risk tolerance and age, you have decided that your portfolio will have 75% stocks and 25% bonds. The market has changed dramatically in the last few months and now your portfolio is 60% stocks and 40% bonds. Your strategy dictates it is time to rebalance, so sell some bonds and buy some stocks. Ignore all the noise in the news about how we are heading to a depression, etc. That way you will always buy low and sell high.
How can loss aversion help us save money or better our lives?
After I read about loss aversion, I also realized that it can be a great self-improvement tool. For example, I was so upset when doing our taxes because I had to take the money from my down payment. I don’t think I would have felt this badly if I had a whole bunch of cash sitting in my checking account waiting to be spent. Just because I had a name to my dollar it increased my pain tremendously. Without realizing it, I have been using this to my advantage for the last few years.
- Targeted saving accounts: I have explained how I have our savings system. Every dollar has a name, only enough for our everyday expenses hits our checking. If we go over the budget that month, we have to take the money from one of our savings pots – vacation, down payment or emergency fund. Know that my overspending is going to make me delay my vacation makes me think any spending decision over and over again. If I had a system of saving whatever is left over, I would have never saved what I save now. The fear of losing my vacation makes me spend less.
- Use loss aversion to develop a habit: We not only have an aversion for losing money, we don’t like losing, period. We don’t like a losing streak. I heard a productivity tip once – Don’t break the chain! If you want to develop a habit, take a calendar and start marking the days you succeeded with the habit with a X. If you do it for a couple of days, you have a chain XXXX. After that you will hate to break the chain, so you will try your best to not break the chain. Do this for a month or two, you don’t need a chain; you already have a habit.
- Get more motivation by framing situations in terms of loss: If you are having trouble finding motivation to get out of debt or succeed in a business, even after thinking about all the potential gain it could bring to you, try framing it in terms of loss. If you earn $10,000 from your business, you will reward yourself with a vacation costing $2500. After a few times of thinking about this vacation, you no longer want to lose your vacation. You will work harder to earn $10,000.
- Trouble developing a habit, bet on it: This is an excellent way to develop a hard habit. Do not feel like hitting the gym to lose weight? Bet to lose money if you don’t lose weight, esp. to someone you don’t want to give the money to. The site Stickk has taken the loss aversion concept to the next level and has developed the smartest way to stick to a goal. You commit to a goal. You also set the stake – if you lose the goal, you are going to lose $x to a charity you don’t support. Get a referee and start working on the goal. As you hate giving $x to the charity you will lose weight.
- Know that other people are susceptible to loss aversion; can you use that to your advantage? We all think we are not sensitive to this kind of behavioral irrationality. We are not weak, are we? As long as people believe that they are very rational, it is a great opportunity for the businesses to take advantage of the irrationality that we fail to acknowledge. Remember the HBO example from above? Comcast is smart enough to know how we think. If you have a business, you should too. Offer free samples of products you are trying to sell; If you are selling a service, also include not just the gain of having your service but what the loss could be if they avoid your service.
Are you a victim of loss aversion too?
Take these two polls.
Oh and what is with the Monkey in the title, I didn’t see that in the post!! Yes, the monkey. Apparently it is not just us, the great humans, who are susceptible to such irrational behavior. (If you chose choice #1 for the first and choice #2 for the second question, you are sensitive to loss aversion). Monkeys, trained to use currency, made the exact same choices we humans do.
We have to be smarter than a monkey right? Let us learn to recognize our weakness and
- Overcome the weakness , not continue to be victims.
- Use the weakness and turn it into strength.
(Image credit: Kabils)