Losses weigh more heavily
Koppel defines loss aversion as the natural preference for avoiding a loss over acquiring a gain. Behavioral economist Daniel Kahneman won the Nobel Prize in economics for his research with Amos Tversky that showed the psychological impact of a loss is two and a half times as powerful as that for a gain.
Koppel recounted one test the researchers did in which they asked people on the street to bet on the flip of a coin for a chance to win $10. Everyone was willing to bet $1, but people thought twice as the stakes rose, and they were rarely willing to wager as much as $6 -- despite having a 50-50 chance of winning each time.
One subject who adamantly refused turned out to be a professional stunt man. "This guy routinely threw himself in front of moving cars, jumped out of second-floor windows and off of moving trains. But to bet $6 on a coin flip to make $10 was outside his risk parameters," Koppel says.
Running from the bear
Joel Larsen, principal of Navion Financial Advisors in Davis, Calif., says loss aversion definitely reared its head during some of the most recent bear markets.
"This is why a lot of people bailed out at the bottom of this last meltdown in '09 … and never got back in," Larsen says.
Statistics from Morningstar show just how volatile the market has been -- and how panic could have caused some investors to lock in their losses. For example, a $10,000 investment made on Oct. 1, 2007 in a Standard & Poor's 500 index fund would have plummeted to just $6,492 by the end of October 2008, a traumatic time for investors following the bailout of Bear Stearns and the collapse of Lehman Brothers, among other calamitous events.
The stock market continued its downward slide through February 2009, at which point the investment's value dropped to $4,983. An investor in a panic who sold at that point would have taken a loss of more than 50 percent. But in March 2009, the S&P 500 began to show signs of life. Had that investor stayed the course, the value of his or her money would have reached $9,396 by the end of June 2011 -- still not a full recovery, but close to breaking even.