How to manage risk in retirement planning

Picture the following two scenarios. In the first, you open your mail and find a check for $500. In the second, you go out to your car and discover a $500 parking ticket. Compare your reactions. You feel great about the check, thinking of fun or practical ways to spend the money. The parking ticket, however – not so much. What a downer! In fact, you might say you feel twice as bad about the loss as you felt good about the gain.

In the past 40 years, the field of behavioral finance has gathered significant data to suggest that our emotions about money can cause us to make errors in judgment of which we are not even aware. In regard to losing money, it appears that the absolute joy from a gain is much less intense than the absolute pain from a loss. The phenomenon is called loss aversion. The way we feel about loss has a huge impact on our investment choices.

Selling winners and losers

Fear of loss can result in a variety of strange and not necessarily rational decisions. We may sell winning investments too soon – to lock in a “sure” gain. Conversely, we may hold onto our losers for far too long. Another weird permutation occurs when, if we face certain loss (such as selling a losing investment), we become more likely to take an even bigger risk, trying to recoup or avoid the loss altogether. This is somewhat akin to the compulsion of a losing gambler who increases his bets in a desperate attempt to regain lost ground.

Use it or lose it

Another reaction to loss aversion is to stay on the sidelines and not to invest at all. If you feel that the only safe place for your money is in a bank, you’re actually taking a great risk because inflation erodes the purchasing power of your money. Although many people contribute to retirement accounts, they never invest beyond that, sticking with what they perceive to be the safest option in order to avoid loss. An excessive sensitivity to loss is actually counterproductive. The advantage of having savings is that it allows us to invest in assets that will appreciate over time, keeping pace with inflation, or ideally, growing at a rate greater than inflation.

Try doing nothing

The most obvious example of sensitivity to loss is panic selling in the market. The feelings generated by losing money are profound – triggering areas of the brain where we experience danger. The need to restore a sense of safety demands that we do something. In this situation, we may feel compelled to act when doing nothing would serve us better. Riding out the storm can be extremely difficult when our emotions are in charge.

In short, we need to manage the pain in order to realize gain. We must put our capital to work for us, taking some risks to avoid others. If we recognize that we are loss averse, we should take only appropriate risks – work to “hit singles and doubles,” to use the analogy of baseball, allowing us to make steady progress toward our goals. Taking the big swing for a home run is not likely to be satisfying enough to offset the pain of the losses that could ensue from being too aggressive or just plain wrong. We need to recognize the effects of the unconscious and emotional forces underlying our choices with money.

Learn more about Jeff on NerdWallet’s Ask an Advisor.