Navigating loss aversion: A guide for Financial Planners

As financial planners, one of your key responsibilities is to help clients make informed decisions that align with their long-term financial goals. A common challenge financial planners face is addressing their clients' loss aversion. Loss aversion is a well-documented phenomenon where individuals experience the pain of losses more intensely than the pleasure of equivalent gains. This can lead to overly conservative investment choices, such as favouring income assets (bonds and cash) over growth assets (equity and property), even when their time horizon allows for growth assets. While income assets provide stability, they usually fail to keep pace with inflation over the long-term, resulting in a significant opportunity cost.

But we all do it

The net flows of the Association of Savings and Investments South Africa (ASISA) categories represent what South African investors do with their savings. As illustrated below, despite the (ASISA) South African Equity General category delivering the best performance since March 2003, it has seen net outflows, while the South African Multi-Asset Income category, with the lowest growth, has gained R300 billion in net inflows. If you look at it like this, our investor behaviour seems irrational and highlights the need for financial planners to guide clients towards a balanced approach that includes growth assets.

Source: Morningstar

It, however, hasn’t been ‘straight line growth’ for the multi-asset income category. If we look at the net flow journey over time (as represented by the cumulative net flow chart below) it is clear that there were a few inflection points for investors. In 2013, the demand for multi-asset income kicked up, in 2019 again and only then settled into a strong straight-line growth for multi-asset income funds since 2020. What do these periods have in common? Poor performance or short-term loss in the calendar years prior. In 2012, the multi-asset income category delivered the top performance for the year, while the multi-asset high equity category delivered a negative return. In 2018, the multi-asset income category delivered the top performance for the year, while the multi-asset high equity and general equity categories delivered a negative return. In 2020, markets were severely impacted by the outbreak of COVID-19 and despite a strong and quick recovery, investors have remained nervous.

Source: Morningstar

How do we help clients?

1.     Recognise the bias

The first step in addressing loss aversion is to help clients recognise their bias. This can be achieved through simple exercises and discussions. For example, present clients with two choices: a guaranteed gain of R1000 or a flip of a coin in which heads will result in a gain of R2000 and tails a gain of zero. Most clients will choose the guaranteed gain, despite the expected value of these two options being the same at R1000. Similarly, when faced with a guaranteed loss of R500 versus a coin toss between losing R1000 or losing nothing, clients often choose the guaranteed loss rather than the chance of losing more. These exercises can help clients understand their level of risk and loss aversion and the potential impact on their investment decisions.

2.     Reframe the perspective

Encourage clients to shift their focus from short-term market fluctuations to long-term financial goals. By extending the investment horizon, the likelihood of achieving positive returns increases significantly. For instance, over a rolling 5-year period, the average multi-asset high equity fund has not experienced a single negative return in nearly 25 years. In addition, it has a 71% success rate of outperforming the average multi-asset income fund over a rolling 5-year period, a 90% success rate over rolling 10-years and 100% over a rolling 20-year period.

Source: Morningstar

Source: Morningstar

Even though 20 years may feel like too long to be relevant, the reality is that clients saving for retirement and even clients early in their retirement have an investment horizon of 20 years and longer, and in many cases 30 years and longer. This long-term perspective can help clients see the benefits of growth assets and reduce the emotional impact of temporary losses. At the end of the day, only equity exposure can meaningfully beat inflation over time, which is what clients need to achieve to grow their wealth and reach financial freedom.

Source: Morningstar

3.     Diversify investments

Diversification is a powerful tool to mitigate risk and provide a smoother investment journey. By spreading investments across different asset classes and different fund managers, clients can reduce the risk of loss caused by a concentrated approach that relies on a single or only a handful of market outcomes. 

Conclusion

Helping clients navigate loss aversion is crucial for their long-term financial success. By recognising the bias, reframing their perspective, and diversifying investments, financial planners can guide clients towards a balanced portfolio that includes growth assets. This approach not only helps clients achieve their financial goals but also ensures their investments can outperform inflation and provide real growth in purchasing power.