Think about the following scenario - Your friend will flip a coin. If it is tails, you lose $100. How much do you need to win if it is heads to take the bet?
Most people say somewhere between $180 to $220. In a perfectly logical world, you should accept the bet if heads results in you receiving $100.01; however, this is not the case for most people. This is because the pain caused from a loss is greater than the happiness caused from a gain.
In The Art of Thinking Clearly the author, Rolf Dobelli, writes the following:
Losing $100 costs you a greater amount of happiness than the delight you would feel if I gave you $100. In fact, it has been proven that, emotionally, a loss “weighs” about twice that of a similar gain. Social scientist call this loss aversion.
In the investing world, risk and potential return go hand-in-hand. There is no “limited downside with huge upside” investment. Return is not a possibility without taking risk. Due to loss aversion, each person usually has a slightly different answer to what risk-return tradeoff they can handle. Furthermore, this is effected by risk capacity. That is, the amount of risk one can actually afford to take. (The risk capacity of a single 20 year old with zero debt is much different than the risk capacity of a 40 year old with four infant children regardless of their risk tolerance.)
The best investment strategy is one that is specific to the individual. This has to take into account a person’s individual outlook on the risk-return tradeoff, which will almost certainly be affected by loss aversion.