That individual investors react more to their financial market losses than to their financial market gains is one of the more well-established behavioral finance theories put forth by Nobel Prize laureate Daniel Kahneman and Amos Tversky, and one that more and more financial advisors are taking into account these days as they seek to apply behavioral finance principles to their practices.
In order to fully comprehend the process behind loss aversion and the impact it has on an individual’s investment portfolios and investment goals, Enrico De Giorgi, professor in the School of Economics and Political Science at the University of St. Gallen in Switzerland and founding partner at Zurich-based firm Behavioural Finance Solutions, believes that financial advisors also need to take into account the fact that all individuals have different “reference points” for their losses and their gains. These subjective mental markers, he says in a recent paper, “A Behavioral Explanation of the Asset Allocation Puzzle,” are the points at which individuals determine where their losses end and their gains begin. Trying to figure them out can go a long way toward understanding loss aversion and coming up with the optimal asset allocation for an individual.
“People care about losses more than they care about gains, and so they penalize losses more than they reward gain,” De Giorgi says. “But where the utility of losses is overweighted compared to gains, the reference point is very important because people don’t only look at the payoff from a particular investment, they have a reference point in mind. They consider an investment a good one if they can fulfill the reference point in mind, and they consider it to be bad if they don’t fulfill the reference point.”
Each person’s reference point is subjective, and most people have multiple reference points. It’s also not obvious how people reach their individual reference points, but regardless, all individuals penalize themselves for not reaching their particular reference points much more than they reward themselves when they do actually reach them, De Giorgi says, because “while you may like reaching your reference point, you don’t like reaching it as much as you dislike not reaching it.”