FinPsych for Feds: Loss Aversion

In the first two installments of FinPsych for Feds, we looked at how we discount the value of the future (present bias) and how we mentally organize our money (mental accounting). Now we turn to another powerful influence on financial behavior: our reaction to loss.

Research from the Universities of Bath and Waterloo (Canada) shows that when people imagine future losses, the emotional impact of dread is more than six times stronger than the pleasure they feel from anticipating equivalent gains. This tendency, known as loss aversion, can have a profound effect on investing, retirement, and career decisions.

For federal employees, it can influence everything from how we react to a falling TSP balance to how we think about giving up a steady paycheck in retirement.

What if someone offered you a choice between receiving $100 with certainty and taking a coin flip in which you could either receive $200 or receive nothing? Which option would you take?

The decision isn’t necessarily obvious. Now change the framing. Suppose you already have $100 and are offered a coin flip in which you can either lose $200 or lose nothing. Most people would be strongly inclined to avoid the gamble.

This example illustrates one of the central findings of behavioral economics: people tend to experience losses more intensely than equivalent gains.

This psychological bias is known as loss aversion, and it is one of the foundational concepts associated with prospect theory, developed by Daniel Kahneman and Amos Tversky. Prospect theory challenged traditional economic models by demonstrating that people evaluate gains and losses relative to a psychological reference point rather than simply evaluating clearcut measures of wealth.

For federal employees and retirees, that distinction can have important consequences.

The Psychology of Losing

Consider what happens when your TSP balance falls sharply during a market downturn. An employee who sees an account decline of $50,000 may experience that decline as a concrete financial loss even though the employee has not sold the investments and locked in the loss. The emotional reaction to the fluctuation in value can be powerful enough to create an impulse to move to a more conservative investment option.

From a psychological perspective, that decision can feel like taking control of the situation. The employee is no longer watching the account decline, but avoiding additional visible losses can create another form of risk. Selling after a decline locks in the loss and may leave the employee out of a subsequent recovery. The original investment strategy may have been appropriate for their time horizon and financial circumstances; what changed was not necessarily the underlying plan, but the employee’s emotional response to a temporary decline.

Loss Aversion and the Retirement Decision

Federal employees face another form of loss aversion when making career and retirement decisions. The accumulation of federal benefits can create a powerful psychological attachment to the status quo. An employee who has spent twenty or thirty years building a federal career may view leaving as giving something up, even if a different choice would better serve their personal goals. Likewise, an employee who is financially prepared to retire may continue working because giving up a salary feels more immediately unsettling than gaining additional time freedom.

The important point is not that working longer is wrong or that everyone should retire as soon as they are eligible. Additional years of work can have substantial financial value.

The critical financial psychology question is whether the decision to delay retirement is being evaluated emotionally through the lens of loss aversion bias.

Avoiding One Risk Can Create Another

Loss aversion can cause us to focus too heavily on visible risks while ignoring less visible ones. Consider a retiree who keeps a very large percentage of their TSP in the G Fund because they cannot tolerate the possibility of seeing their investment balance decline. In allocating most of their TSP balance to the G Fund, the retiree has successfully reduced market volatility, but this decision has not eliminated risk. Over a retirement lasting twenty or thirty years, inflation can substantially erode purchasing power. Instead of avoiding risk, the retiree has simply exchanged one type of risk for another. (There’s also some present bias at play here, since the losses he’s avoiding are present-day losses, but the purchasing power erosion won’t be felt until 10+ years into the future, it may be more difficult to take corrective action.)

A useful way to counter loss aversion is therefore to broaden the question. Rather than asking only, “How much could I lose if I do this?” ask, “What could I lose by not doing this?”

An employee considering a diversified investment strategy should consider not only the possibility of market losses, but also the consequences of insufficient growth. Someone considering retirement should consider not only the loss of salary, but also the value of additional years of time freedom. A retiree considering a spending decision should consider not only the possibility of having less money later but also the possibility of unnecessarily restricting the life that the savings were intended to support.

This reframing does not mean ignoring losses. Losses matter, and prudent financial planning should take them seriously. This approach simply recognizes that risk is multidimensional. Avoiding one kind of loss can leave us over-exposed to another.

Perhaps the most important discipline during periods of financial stress is to distinguish between a change in circumstances and a change in feelings. If markets decline, ask whether your financial circumstances have actually changed. Has your retirement date changed? Has your expected spending changed? Has your income changed? Has the purpose of the portfolio changed?

If the answer is no, the urge to make a dramatic change may be coming primarily from the emotional experience of loss. That emotional experience is real, but it’s not evidence that the underlying financial plan is wrong or defunct.

Loss aversion reminds us that the psychological experience of money is not the same thing as its mathematical reality. The challenge is not to become indifferent to losses, but rather to ensure that the fear of one particular loss does not cause us to overlook other risks that matter just as much.

Present bias helped explain why we prioritize today.
Mental accounting helped explain how we organize our money.
Loss aversion showed us why trying to protect what we already have can sometimes become more important than pursuing what we believe we need.

But even after having examined these emotional influences, there’s another question that emerges: How do we decide what information to believe in the first place?

That’s where the final installment of FinPsych for Feds will pick up next week! Join us as we explore confirmation bias and anchoring bias, and how they can shape the financial conclusions we reach.

**Written by Katelyn Murray, CFP®, ChFEBC®, FBS®, CFT-1™, ECA. The information has been obtained from sources considered reliable but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Katelyn Murray and not necessarily those of RJFS or Raymond James. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy suggested. Every investor’s situation is unique and you should consider your investment goals, risk tolerance, and time horizon before making any investment or financial decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. **