How Loss Aversion Affects Investment Decisions

Behavioral financial analysts have conducted a significant amount of research in order to understand how investors process loss. In the process, they have found out that most investors have an innate aversion to losses. This causes them to make wrong decisions while investing. In this article, we will have a closer look at what loss aversion is and how it impacts the psychology of the people investing in the stock market.

What is Loss Aversion?

There is a famous saying in Wall Street. The saying goes like this, “There are two rules in financial markets.”

Rule #1: Don’t lose money

Rule #2: Don’t forget rule #1

This saying explains the psychology that drives a lot of investment decisions. Investors often become psychologically involved with their investments. This is the reason that they see a financial loss as a personal failure. For instance, ideally, investors should get about the same amount of joy from earning $500 as compared to the pain they would get while losing $500. However, researchers have conducted studies and concluded that the pain of losing money is actually far greater than the joy of earning money. This is the reason why investors make a lot of irrational decisions in order to avoid that pain.

Some of these irrational decisions have been listed below:

Early Profit Booking: A lot of investors are fixated on finding winners. This is the reason that if they invest in a stock and it rises even slightly, then the investors want to book their profits and exit the investment. This often means that even if they find a winner, they are not willing to provide it enough time to reach its full potential.

Instead, as soon as the rising price shows the slightest downtrend, investors exit the stock due to loss aversion. They are unable to think rationally. Instead, they are driven by the need to appear to be a success and can’t risk being seen as a failure.

Obviously, if profits are booked too early, then the investors lose out on opportunities. In the short run, investors may feel like they have earned money. However, in the long run, they would have lost out on significant opportunities.

Smart investors try to control their innate loss aversion tendencies and hold on to a stock if it has the potential to be a winner.

Holding on to Losers: Loss aversion causes investors to do the exact opposite of what they should be doing when faced with a losing stock. Let’s assume that an investor buys a stock, and it goes down in value because its fundamentals have deteriorated.

Loss aversion fallacy will cause the investors to hold on to the stocks despite there being no future for them. Selling the stocks at a loss would be seen as a personal loss to the investors. Hence, they do not sell the stocks because they feel that sooner or later, the prices will recover. However, because of this fallacy, investors often forget that there is a time period involved in the calculation as well.

For instance, if an investor buys a stock for $100 and sells it for $101 after two years, he/she has earned just 0.5% return on an annual basis. However, since loss causes them immense pain, they are willing to do so.

A good rule of thumb for investors is to check their portfolio. If their portfolio has a couple of winners followed by numerous losers, they are probably affected by loss aversion.

In most situations, people keep churning the winners while irrationally holding on to the losers.

Taking Excessive Risks: Loss aversion often causes investors to take a lot of unnecessary risks. For example, if investors face a loss, instead of accepting the loss, they often try to gain from it.

A common strategy is called averaging out the prices. This means that if you have 100 shares of a company at $10 a share and the price slips to $8, investors tend to buy 200 shares. This is done so that the average cost of the share is reduced. In this case, the investor would now have 300 shares at $260, i.e., at $8.66 per share.

The idea is that now if the share moves to $9 per share, they would recover the losses of the earlier lot purchased at $10 as well. This is a fallacy because buying or not buying at $8 should not depend on the earlier decision. This sort of behavior is often seen in casinos wherein gamblers tend to double their bets to recover their previous losses. The problem with this strategy is obvious.

If the prices don’t move up and actually move further down, then the losses get multiplied!

Avoiding Equity Stocks: In some cases, investors have burnt their hands so badly that they avoid any kind of investing in equity markets. Instead, they keep most of their funds tied up in fixed income securities. This is detrimental for young investors who may have a risk appetite.

Sell Offs: Most importantly, loss aversion causes people to panic and try to cut their losses when the market goes down sharply. This is the exact opposite of what should be done.

Smart investors are the ones who are buying when the market is going down.

The bottom line is that investors must be aware of the psychological fallacy of loss aversion. Awareness will help them manage the emotions and therefore earn superior returns.