Disentangling Loss, Risk and Regret Aversion in Financial Decision-making

Would you accept a 50-50 bet to lose $100 or gain $200?

Loss aversion is the term we use to describe the dislike of accepting such bets.

You might have heard that we are loss averse because the pain of losses is 2.5 times greater than the joy of gains. Therefore, we decline such bets because the $200 potential gain is only twice the $100 potential loss.

But are we loss averse?

I regularly offer this bet to my students. Virtually all accept it. Are my students uniquely loss tolerant? Not really. Indeed, a prominent study found that approximately half of Americans are loss tolerant.¹

Instead, my students’ responses indicate that the concept of loss aversion needs clarification.

Loss Aversion vs. Risk Aversion

Loss aversion and risk aversion are related but not the same. Compare an investment assuring no losses to one with potential losses not exceeding 1% and to another with potential losses not exceeding 20%.

Risk-averse investors readily accept investments assuring no losses, are somewhat averse to investments assuring losses not exceeding 1% and are much more averse to investments assuring losses not exceeding 20%. In other words, their risk avoidance increases gradually as potential losses increase.

Loss-averse investors are different from risk-averse investors in their desire to avoid any losses, even as small as 1%. Loss-averse investors, unlike risk-averse ones, are not much more averse to investments assuring losses not exceeding 20% than to investments assuring losses not exceeding 1%.

Is Loss Aversion an Error?

Loss aversion is often described as a cognitive error, but is it always an error? Suppose you are an advisor to clients who reject 50-50 bets to lose $100 or gain $200.

To find out if their choices are motivated by an error, try framing the bets differently. Ask your clients to begin by thinking about their total wealth. Next, ask whether they are willing to accept 50-50 bets to have their wealth minus $100 or plus $200.

Some clients might accept the bets in their new “wide framing,” which includes the awareness that $100 potential losses are minuscule relative to their total wealth. In contrast, the $100 potential losses might loom large when presented in “narrow framing” without considering the bigger picture of total wealth.

Such reversals indicate that their earlier choices to reject the bets were errors, the outcomes of narrow framing. Other clients, however, might reject these bets despite having total wealth in the millions.

Loss Aversion vs. Regret Aversion

Regret is the emotional sting we feel when we contemplate past choices and find, in hindsight, that we would have been better off if we had chosen a different option.

Regret is a “cognitive emotion” as we can contemplate its potential future sting before making our choice, for example, to buy Apple or Alphabet shares or whether to accept an Apple job offer or an Alphabet one. Regret differs from fear, which comes instantly without cognition.

Money market mutual funds directed at individual investors use “dollar” accounting in which the net asset value (NAV) of shares remains at $1, rather than the “mark-to-market” accounting used by all other mutual funds, whereby the NAV of shares goes up or down as the prices of bonds and stocks go up or down.

Mutual fund companies strive mightily to avoid “breaking the buck,” that is, being compelled to reduce the NAV of their money market shares below $1, but they don’t guarantee it. Indeed, during the financial crisis of 2007-2009, some mutual fund companies were forced to break the buck by reducing the NAV of their money market shares from $1 to $0.99 or $0.98.

You likely also know that in the aftermath of the financial crisis, the U.S. Securities and Exchange Commission (SEC) proposed to abolish money market funds’ dollar accounting and switch them to market-to-market accounting.

Mutual funds companies fought vigorously against this proposal and ultimately struck a compromise whereby money market funds directed at individual investors were allowed to maintain dollar accounting, and money market funds directed at institutional investors were allowed to apply mark-to-market accounting.

Why did mutual fund companies fight so vigorously to maintain dollar accounting? The answer is a combination of loss aversion and regret aversion.

Compare buying a TV for $1,000 with a check written on your bank checking account to a $1,000 check written on your money market account that uses mark-to-market accounting when the NAV of shares at the time you write the check is $1 per share.

If your $1,000 check were written on your bank checking account, you’d see an exact $1,000 reduction in the balance of your account. But suppose the NAV per share of your money market shares declined from $1 to $0.98 as the check made its way from the merchant to your money market account. You’d see more than a $1,020 reduction in your money market balance as if you had paid more than $1,020 for the TV.

The $20 difference probably wouldn’t break your budget; it amounts to no more than the price of a few Starbucks lattes. But you’d feel the sting of regret. Why didn’t I buy the TV a few days earlier when the NAV of my shares was $1? Why didn’t I buy the TV a few days later when the NAV of my shares increased to $1.02?

My Loss Aversion and Regret Aversion Story

In mid-2021, I transferred the balance of my money market mutual fund to an intermediate-term bond fund. The money market fund paid almost zero interest at the time, whereas the bond paid perhaps 2% interest. Both funds allowed me to write checks on them.

The bond fund used mark-to-market accounting, however, so it could impose losses as interest rates increased. Yet I reasoned that my loss aversion was small relative to the large interest rate advantage of the bond fund.

One argument against the SEC proposal to switch the accounting method of money market funds from dollar accounting to mark-to-market accounting was that it would require tracking capital gains and losses, a headache at tax-return time.

However, this argument is invalid because mutual fund companies calculate our capital gains and losses, even taking account of wash sales and presenting the total before tax-return time.

All went well in 2021, so I took pride in my transfer wisdom. But losses began to mount in 2022 as interest rates increased. It turned out that my loss tolerance was lower than I thought, and my regret aversion was higher than I thought. I transferred half my money back from my bond fund to my money market fund.

Understanding Loss, Risk and Regret Aversion to Better Support Your Clients

While many clients may know the term loss aversion, the concept might need clarification. It is helpful to distinguish loss aversion from risk aversion and regret aversion.

While not always an error, loss aversion can be an error when exaggerated. For instance, it can make clients keep too much of their portfolios in money market funds.

Yet, gauging clients’ loss, risk and regret aversion is wise before suggesting portfolio changes, knowing it's easier to overcome loss aversion before actually experiencing it.

¹Jonathan Chapman, Erik Snowberg, Stephanie Wang, and Colin Camerer, “Loss Attitudes in the U.S. Population: Evidence from Dynamically Optimized Sequel Experimentation (Dose), CESifo Working Paper No. 7262 (October 2018). Available at SSRN.

GLOSSARY

Money market mutual funds. These funds invest in short-term debt instruments (e.g., commercial paper, U.S. Treasury bills, repurchase agreements) and are valued for their relative safety and liquidity.

Net asset value (NAV). The total value per share of all the underlying securities in a portfolio.

Wash sale. This is a transaction in which an investor sells securities at a loss to reap tax benefits and then repurchases the same or significantly similar security within 30 days before or after the sale.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

References to specific securities are for illustrative purposes only and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and are subject to change without notice.

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

The opinions expressed are not necessarily those of Avantis^® Investors. This information is for educational purposes only and is not intended as investment advice.

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