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Market fall reveals your risk tolerance and loss aversion

"Each person has to play the game given his own marginal utility considerations and in a way that takes into account his own psychology. If losses are going to make you miserable – and some losses are inevitable – you might be wise to utilise very conservative patterns of investment and saving all your life. So you have to adapt your strategy to your own nature and your own talents. I don’t think there’s a one-size-fits-all investment strategy that I can give you.”

- Charlie Munger, 1998, answering, "How do you learn to be a great investor?"


A week ago, the S&P/ASX200 entered what is known as a 'market correction' when it fell more than 10% during January 2022. At the time of writing, like the US S&P500 and NASDAQ, the index has recovered some ground, but here are the moves since the start of the year.


Experiencing a 10% fall is a good time to take stock of your risk tolerance. If you held $1 million in equities and the value fell $100,000, what did you think?

A) No big deal. That's the price of investing in shares and I'm focussed more on the long term, OR

B) $100,000!!! What I could do with $100,000! That's a year of hard slog to earn that much. There goes the mortgage repayment and new car.

Or maybe a worse reaction if you are in retirement and living on your savings. Retirement planning requires guesswork about the future, and 'losing' 10% might seem like a big hit when you are carefully drawing down 4% a year.

Are you someone who welcomes lower share prices as a buying opportunity, or loses sleep when the market falls? What if it goes down another 20%? Or 50%? If this seems unlikely, consider the following chart from Ashley Owen of Stanford Brown. In the last 100 years, there have been 44 falls of over 10%, meaning equity investors should expect one every couple of years. And a 50% fall has happened every 25 or so years. 

There is no single and simple answer to how much market risk an investor should take. There is a difference between 'risk tolerance' and 'risk capacity' but we tend to interchange the two. Tolerance is an investor's comfort (or discomfort) with risk, whereas capacity is how much risk an investor can take without ruining their financial plans.

Tolerance for risk

Everyone has a different loss discomfort level and it varies over time and according to market conditions. While any number of risk appetite tests can be done in advance, nobody knows their tolerance until they face a real rather than imagined loss.

Some people genuinely look to an investment horizon decades into the future and have a strong ability to ignore market noise and fluctuations. They remain heavily exposed to equities for long-term growth and are sanguine about the potential for half their retirement savings to be wiped out.

But they are likely in the minority. For many, a $100,000 correction means doubt sets in, as it might be heading towards a loss of $200,000 or $300,000 which would compromise plans. In choosing to sell before it gets worse, another investor exits in a down market.

There is a common argument that younger people have greater risk tolerance, because they have more time to recover from a drawdown. But often the young person is saving over a shorter-term horizon than retirement, especially the deposit on a house, and a loss can be a setback toward the Great Australian Dream. Young people suffering a market loss may be discouraged from investing later in their lives.

Lack of capacity for losses in older people

Retirees may be hit by a market fall at the point when their retirement savings are at their maximum, the so-called ‘sequencing risk’. A loss of capital at a time of regular withdrawals may reduce the estimated period until the money runs out.

National Seniors Australia released a survey of nearly 5,000 of its members in 2018 which showed little capacity to tolerate losses in retirement savings. About 23% reported they could not accept any annual loss on their portfolio, as shown below. Most respondents could not tolerate losses of over 10%, and only one in 14 a loss of 20% or higher (note in the table that the large box on the right is ‘can’t say’). National Seniors reported:

“Of those who could quantify their risk tolerance, only 11% could tolerate a loss equal to the impact of the GFC. Those who admitted in the survey to not knowing how to manage their market risk are twice as likely to report ‘no tolerance for any loss’ as those who said they could manage it.”

The theory of loss aversion under challenge

We’re all different but if there was one widely-accepted behavioural trait, it was that most people are influenced by ‘loss aversion’. Loss aversion is a notion that we dislike losses far more than we enjoy equivalent gains. Daniel Kahneman, the 2002 Nobel Prize in Economics winner, in his bestselling book, Thinking Fast and Slow, went as far as saying:

“…the concept of loss aversion is certainly the most significant contribution of psychology to behavioral economics.”

His colleague, Richard Thaler, was awarded the 2017 Nobel Prize in Economics, and ‘loss aversion’ featured 24 times in the Nobel Committee’s description of his contributions to economics.

It seems to reflect a fundamental truth. Dozens of academic studies have attempted to quantify loss aversion, and Kahneman says:

“You can measure the extent of your aversion to losses by asking a question: What is the smallest gain that I need to balance an equal chance to lose $100? For many people the answer is about $200, twice as much as the loss. The ‘loss aversion ratio’ has been estimated by several experiments and is usually in the range of 1.5 to 2.5.”

It doesn’t seem logical, but for many years, I have used the following slide to reveal how loss averse people are. Say someone does a day’s work, and is offered two payment alternatives, as shown. The expected value of A) is $840 (80% X $1,000 plus 20% X $200) and B) is $800, yet nearly everyone chooses B). In fact, when I change the slide to lower B) to $600, most people still want the certain payment rather than the gamble.

However, now there is a body of work saying loss aversion is a fallacy, that there is no general cognitive bias that leads people to avoid losses more vigorously than to pursue gains. For example, David Gal, Professor of Marketing at the University of Illinois at Chicago, writing in Scientific American, says:

“People do not rate the pain of losing $10 to be more intense than the pleasure of gaining $10. People do not report their favorite sports team losing a game will be more impactful than their favorite sports team winning a game … To be sure it is true that big financial losses can be more impactful than big financial gains, but this is not a cognitive bias that requires a loss aversion explanation, but perfectly rational behavior. If losing $10,000 means giving up the roof over your head whereas gaining $10,000 means going on an extra vacation, it is perfectly rational to be more concerned with the loss than the gain."

Yet Kahneman’s statement that ‘losses loom larger than gains’ has much support and to me, feels right, based on my personal experience with investing. I don’t enjoy gains anywhere as much as I dislike losses, and it influences my investing. I have long accepted the estimate that loss aversion:

”…is a cognitive bias that describes why, for individuals, the pain of losing is psychologically twice as powerful as the pleasure of gaining.”

But even Kahneman now says loss aversion was not so much the result of rigorous experiments as an intuition. When David Gal reproduced a typical Kahneman study about how much students would sell their mugs for, he found his subjects were largely indifferent. The desire to buy or sell at certain prices was met more with inertia than a feeling of gains or losses. Other researchers have expressed similar concerns, arguing that we are not hard-wired to give negative results such significant weights. So Gal calls loss aversion theories ‘fuzzy and loose’, when often actions can be explained by other factors such as the endowment effect or a bias towards inaction.

Asked to react to Gal’s work, Kahneman, now aged 87, said:

“It’s not a law of human nature that you have to find it in every context ... There are experiments where people don’t find loss aversion. And, again, there’s an explanation for every one of them. That doesn’t violate loss aversion, because there are exceptions to loss aversion ... Having a principle that helps understand a wide body of phenomena - that’s considered useful. That doesn’t mean that loss aversion’s true. It means that it’s useful.”

Find your own risk tipping point

As Munger said: "If losses are going to make you miserable – and some losses are inevitable – you might be wise to utilise very conservative patterns of investment and saving all your life."

But an investor with a highly-conservative, long-term portfolio will forgo substantial returns over multiple decades, and the opportunity cost might deliver as much angst as a short-term market loss. It would feel like everyone else is drinking punch and dancing at the party while you're lying at home in your bed.

The best strategy is to find that point where there is enough equity market exposure to enjoy the gains, but not too much that losses cause great worry. If being a little conservative is what it takes to get a good eight hours, it might be worth the cost. 


Graham Hand is Managing Editor of Firstlinks. This article is general information and does not consider the circumstances of any investor.


Jon Kalkman
February 07, 2022

It is interesting that the discussion about risk tolerance always focuses on the market value of assets and so older people become more risk averse and invest in conservative assets such as term deposits, even though the income from term deposits has fallen almost 90% since 2007. And yet with the current interest rate is 1%, they are eating through their assets at an alarming rate and dramatically increasing their longevity risk.
Because the bills don’t stop in retirement, predictably of income is much more of a problem to us. As long as we do not need to sell shares in a falling market, dividend income is much more stable. That risk is managed by holding several years of expenditure in cash so that shares are never sold at a bad time and we can ride out the market volatility.
Dividend income is also tax advantaged and likely to grow over time. We call our share portfolio our orchard, that we harvest every year, but we never chop any trees down for firewood.

David Williams
February 06, 2022

Quotes from the article (which I enjoyed):
"Tolerance is an investor's comfort (or discomfort) with risk" Yes
"Capacity is how much risk an investor can take without ruining their financial plans". Isn't it how much LOSS?
"Tolerance for risk: Everyone has a different loss discomfort level and it varies over time and according to market conditions. While any number of risk appetite tests can be done in advance, nobody knows their tolerance until they face a real rather than imagined loss". My understanding is that 'financial risk tolerance' is a trait and does not vary significantly over time or with market conditions. Australia's world class Finametrica Risk Tolerance system makes that point. Since Finametrica is now a Morningstar service, I'd love to see them comment on this fascinating discussion.

Neil Currin
February 06, 2022

I am just a simple common sense guy. Two ordinary people A and B. Both believe in Scott Pape’s Idiot Grandson Investment.Portfolio. 75% VAS, 15% VEU 10% VTS. Invest and Forget.

Both have $1 million. Both will invest the funds when available as per Scott Pape’s suggested Investment Portfolio.

A funds become available in Feb 2020. $775 in VAS $89.27 per share $15K in VEU $79.97 per share, $10K in VTS $254.92 per share.

B’s Funds only available 20th March 2020.
$775K in VAS $60.00 per share, $15K in VEU $61.00 per share, $10K in VTS $190.00 per share.

Share price 4 Feb 2022:
VAS $91.09, VEU $84.95, VTS $318.00.

Value of A’s portfolio 4 Feb 2022

Value of B’s Portfolio 4 Feb 2022
$1213.9K. Difference $398K.

Warren Buffet, Charlie Munger, Scott Pape, Twiggy and many other rich people but not when the share prices is lower. Average person invested all their available cash.

We can’t time the market. The average middle class investor is at the hands of Lady Luck. Am I missing something???

SMSF Trustee
February 07, 2022

Neil, I suspect that what you're missing is that the ''average middle class investor'' will have gradually invested, via superannuation guarantee charges, over many years and won't have had the starting point risk that your example relies upon. They will have bought into the market at high points, low points and all sorts of points in between, in roughly equal measure.

Sure, people who get a windfall and choose to invest it all at once will see outcomes that depend to a greater extent on their starting point. I think of many who jumped on Peter Costello's generosity in 2007 or thereabouts and plunked their extra $1 mn or so into shares within their super at the top of the market. Yep, they'd have been better off waiting until March 2009 (as long as they could keep Roubini's perpetual pessimism out of their ears) - by about 4% per annum since then!

But, this isn't just ''lady luck''. This is the consequence of a dumb strategy. I don't know who Scott Pape is, but putting a windfall into the market all at once is just stupid, if you want to optimise your return into the future. Of course, it's a windfall, so any gain over time is great, isn't it? That $1 million in 2007 has still earned a total return way above inflation (shares since then have done over 6% pa). If income was reinvested it's now worth just over $2 million. That's not too shabby!

Finally, you seem to think that ''rich people'' somehow don't face this same uncertainty. Not true. No one knows with any certainty when markets will peak and trough. What they don't do is invest everything at once and, most of them, don't set and forget. They're active, topping up when markets pull back, trimming exposure when they've been on a run, thus biasing their average buy-in levels down a little.

So, seems to me you're missing quite a bit.

Steve Dodds
February 09, 2022

There is considerable evidence that, on average, you are better off investing a 'windfall' all at once rather than trying to time the market or Dollar Cost Average.

DCA works when you don't have a lump sum, as in the super example you mention. But even with super, you are better off using the bring forward method and investing a $300K lump sum, for example, rather than dole it out over three years.

Of course this evidence is little consolation if you happen to lump sum just before a slump and need short-term returns. But if you need short term returns you shouldn't be investing in shares anyway.

February 04, 2022

That National Seniors stuff combined with the share chart says everything about why folk miss out on share gains. Over half can't tolerate a loss of 10% in their portfolio, yet the market falls 10% every two years. So where else is your money. Are you drawing down 5% and earning 1%? You know what that means.

February 05, 2022

Most retirees (and investors in general) wouldn't have all their money in the stock market. If you have half your money in stocks and half your money in cash/TDs/bonds then your chances of a 10% fall are a lot lower, but you're still getting a reasonable return.

Also a lot of people say that they can't tolerate that sort of fall, but don't notice it when it happens in their super/pension fund because they rarely/never look at it. In which case they effectively can tolerate it.

February 06, 2022

The numbers are the numbers, but I was surprised by the chart showing how often the market falls substantially. Maybe I'm not as attuned to losses as I thought. I had not noticed so many over the years, or more likely, I've forgotten.

February 02, 2022

Thanks Graham, great article. I’m assuming the last entry in Owen’s graph should read for 2022 and not 2020?

Graham Hand
February 02, 2022

Thanks, Steve. It's been a big day with both Ashley and I presenting at the Morningstar Investor Conference, but we'll get it right in the next version.

Howard Coleman
February 02, 2022

With our Teaminvest members we find that when share prices drop significantly, we can divide the reactions of our members into two categories:
Those who more deeply understand the businesses in which they invest, are pleased with the drop in share prices and use this opportunity to add to their positions.
Those who have a shallow understanding of the same businesses, worry that "the market may know something" and are more likely to panic and sell.
So loss aversion is heavily dependent on their depth of knowledge of the businesses in which they're invested.

Jack Russell
February 06, 2022

This ignores the fact that sentiment plays a significant role in determining market price. An investor can evaluate a business to be worth a certain figure but it won’t matter 1 iota if market sentiment is against the stock price. Naive to say the least. Even the hybrids can fall 35% in a crash due to sentiment (and liquidity). PERLs in the GFC. Why stay in a security that falls that amount when an exit point can be made at much higher levels saving capital.

ashley owen
February 02, 2022

hi graham,
excellent story. But is important to remember that the red bars in my chart are not 'losses' unless you sold at the bottom (or worse still, were sold out by a margin lender).
There are two main definitions of 'risk'. (1) The real world definition of risk - we and our readers see risk as a permanent loss of capital; but (2) academics define 'risk' as temporary price volatility.
The main causes of permanent loss of capital (ie real risk) are (a) fraud/theft/scams; (b) failed shares/assets; (c) taxes; (d) fees; and (e) poor decisions triggered by temporary price volatility (eg panic selling at the bottom, or gearing up at the top and being sold out at the bottom, etc).
So the scary looking red bars in the chart were all just temporary (some lasting just a few days), and every one of these falls was followed by even larger gains! They were not losses at all if you held on to them.

February 02, 2022

Most people don't mind taking a risk! Until they loose their dough!

February 02, 2022

Whenever we have a correction, I always look back to when my portfolio was last at the same value. For this current correction that was the first week of July 2021. This removes the noise and gives the correct perspective. For the FY I am still ahead and there remains plenty of time to make a modest gain.

Peter Sheahan
February 02, 2022

Ditto....I do too.

February 02, 2022

Risk = consequence x chance

February 02, 2022

What a brilliant article Graham! Many thanks.
Alan B's metaphor was also an extremely interesting way to frame the discussion.

February 02, 2022

The Ashley Owen Mkt Falls Chart has an omission - the collapse of March 2020 - just under 30%.

Graham Hand
February 02, 2022

Thanks, Rob. The slide is being updated. G

February 02, 2022

Loss aversion depends on the proportional magnitude of the potential loss and potential gain. The greater the loss, the more the aversion. The greater the gain the less the aversion. This is both logical and rational behaviour.
Perhaps your illustrative slide needs to be amended with following example.
Let's say you have $500,000 to invest. #1 financial advisor offers you a plan that has an 80% chance of returning $1,000,000 and a 20% chance of returning $200,000.
#2 financial advisor offers you a plan that has a sure payment of $800,000.
Which financial advisor do you go with? Of course #2.
But would your answer be different if you had just $1000 to invest?
Personally, I wouldn't trust either #1 or #2.

February 02, 2022

Might be overthinking it Alan.Personally I don't use advisors. Jeff Bezos can lose or gain $5billion in a day,not a problem. If you have a few million and lose half,not a problem. Have a few hundred K and you have a problem if you lose half, it really is a game of controlling emotions. 

February 05, 2022

It is different if you can take the bet over & over thousands of times in your life if that bet is your payment for every day in a job. In that case, the higher expectancy of $840 would win out over time as the noise gets smoothed out. But if you can only take this bet once in your life like in the financial planner example with the $500k investment, then you are better off with the guaranteed $800k because you only live once and the utility of extra money diminishes the more you have, but losing $300k close to retirement if that is all you have would be very detrimental.


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