Loss Aversion

Last update - 7 December 2020 By UserName LastName

It sounds like I’m stating the bleeding obvious in the title, huh! I mean, who isn’t averse to losing money and who isn’t partial to a profit?! But things are a little more interesting and complex than that.

A long-held Rivkin rule stipulates that ‘the pain of losing money is greater than the pleasure of making money’. The reason this statement holds is due to human beings’ innate aversion to loss. Studies have demonstrated that losses can, in fact, be as much as twice as psychologically powerful than gains. That is, the pain of losing money is approximately twice as powerful as the pleasure gained by making money. Put yet another way: it’s better not to lose $100 than it is to find $100.

From an evolutionary perspective, it makes sense that it is far more motivating to protect what we already have than it is to seek to increase what we have. As such, it would seem that our ancestral risk-takers, who were perhaps a little too cavalier in seeking to increase their fortune, were ultimately met by a most Darwinian fate. In contrast, those who fervently protected what they had never went hungry and lived long enough to procreate and set their genetic material into perpetuity.

Back to the 21st century, and we can see that many investors find the idea of selling stock when they are down simply too painful to face. Instead, they hang on in the vain hope that one day the stock will come good. And of course, it might come good, however, if the reason you originally bought the stock has not come to fruition, not selling is simply a failure to acknowledge reality. This psychological investment trap is also known as the sunk-cost trap, which is about psychologically (but not in reality) protecting your previous choices or decisions — which is often disastrous for your investments. It is tough to take a loss and/or accept that you made the wrong choice. But if your investment is no good, or sinking fast, the sooner you get out of it and into something more promising, the better.

Loss aversion is the cornerstone of the insurance industry when you think about it and can prevent us from assuming risk; however, some measure of risk-taking is inherent to the very nature of investing. Thus, it is important that we recognise this cognitive bias in ourselves and actively work hard to fight the instincts that lie within us all. Imagine if we refused to realise losses on the stocks we were down on, and we simultaneously locked in profits only on those stocks we were ahead on. Here we are avoiding the ‘realisation’ of loss as we find it too painful, however, what kind of portfolio would we be left with if we got rid of every performing stock while we tightly held onto those that had fallen in value? It would be an ugly portfolio, that’s for sure.

There’s an old saying in stock markets that good investors run their profits and cut their losses. The problem is, most investors do the exact opposite thanks to loss aversion… they cut their profits, all excited to lock them in and take them to the bank, while they run their losses, their only strategy being one of ‘wait and hope things improve’. The act of realising the loss is too hard to bear. The funny thing is, the loss is still there on paper, but it’s only in selling it that one must finally acknowledge and quantify the loss. But that’s a far better outcome than remaining in dreamland and convincing yourself that your losses aren’t quite yet losses unless or until you realise them. They are still losses, and even worse, the capital that’s just sitting there and slowly being eroded isn’t doing better things for you in another investment as it should be doing.

I can comfortably say that I have cut my profits (only to see the stocks go higher) and run my losses (only to see the stocks go lower) countless times and almost without exception, nothing good has come from it. This cognitive bias is natural, but now that you know about it, you have the power to override it.

 

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