Human beings are prone to a variety of behaviors that make them bad investors, and in an article for The Economic Times, Vivek Kaul looks at a major one: “loss aversion”.
First identified and named by psychologists Daniel Kahneman and Amos Tversky, loss aversion is a phenomenon in which “people tend to base their decisions on perceived gains rather than perceived losses because the emotional impact of losses is far greater than that of gains,” Kaul writes. “Extensive research in behavioural economics shows that people experience twice as much pain when they face a loss in comparison to the pleasure they feel with a gain.” That fear of pain makes people prone to holding onto losing positions, rather than locking in a loss, even after they know they should sell.
Locking in a loss also means admitting you’ve made a mistake, Kaul notes, which is very hard to do. He quotes from Wall Street Journal columnist Jason Zweig, author of Your Money and Your Brain: “When you sell a loser, you don’t just make a financial loss; you take a psychological loss from admitting you made a mistake. You are punishing yourself when you sell.”
Loss aversion stems from short-term thinking that many investors are susceptible to, which has other negative impacts. “People tend to keep their money in safe debt instruments rather than in equity, despite the promise of higher gains in the latter, because the risk, and the implied loss, in equities is enough to keep them away from the high returns,” Kaul writes. “What they don’t realise is that the low returns in safe options will not be able to keep pace with inflation, reducing the purchasing power of their funds several years down the line.”
Kaul offers a few ways to avoid loss aversion bias. Among them: calculating how much a loss in one stock or fund will impact your entire portfolio before you decide whether to sell or hold, using stop-loss orders, and remembering that short-term losses can be used to offset short-term gains for tax purposes, helping you save some of the money you lost on the position.