Understanding Sensitivity to Loss

Nobody likes losing money, but our Sensitivity to Loss score measures people’s increased levels of pain associated with financial losses. It is measured on a scale of 0 to 100, where 0 represents a standard level of sensitivity to losses and 100 represents a high sensitivity to losses. Most people have a score between 0 and 20, with 50% of clients having a score of 0.

Sensitivity to Loss is independent of Attitude to Risk and is a critical component of understanding an investor’s complete risk profile.


What is Sensitivity to Loss?

Below is a sample distribution of investors’ Sensitivity to Loss scores from hundreds of thousands of clients in a live commercial environment:

John's sensitivity to loss score: 0

Identifying Sensitivity to Loss in client decisions

A client’s Sensitivity to Loss can be estimated using their decisions on the slider. We reveal this by noting the degree to which the client reduces the risk they are comfortable with as the opportunity decreases. It is normal for clients to somewhat reduce the risk they take as the opportunity decreases, but in cases where clients significantly reduce their risk-taking as the opportunity decreases, we can observe that they are loss averse.

However, if a client risks a similar amount of their investment across each scenario, then we calculate that they have no additional Sensitivity to Loss.

Sensitivity to Loss Score: 0
Sensitivity to Loss Score: 36

What’s underneath the Sensitivity to Loss score?

Our scores are grounded in science.

We use a two-parameter utility function that allows us to identify a range of behaviours in users’ decision making:

  • The first parameter is alpha (α), and it represents the extra probability weight the user puts on the loss. We calculate the Sensitivity to Loss score by scaling this parameter α.
  • The other parameter is rho (ρ), and it impacts the curvature of the user’s utility function. The Attitude to Risk score is based on the risk premium of the estimated utility function, which is impacted directly by ρ.

Prospect Theory observes that people feel the pain of losses at higher rates than they feel satisfaction from equivalent gains. Our science goes beyond the research of Prospect Theory and measures the utility each individual receives in relation to perceived gains and losses.

By using mathematics to understand people’s preferences, we can precisely measure how satisfied they will be with each investment option and find the right investment portfolio for them.

Knowing where each of your clients sits on this distribution is integral for understanding their preferences and personalising the advice you give them. To learn more about how to advise highly loss-averse clients, see our article on Example Client Personas.

To learn more about our science, you can check out our white paper: New Ground in Financial Risk Tolerance.

Did this answer your question?

If not, please feel free to reach out to us at customer-support@capitalpreferences.com