Loss Aversion
After discussing sunk cost fallacy, we will discuss Loss Aversion in this blog.
It's one of the most common biases seen not only in investing & but also in our lives.
So what is Loss Aversion?
Loss aversion is a cognitive bias that describes why the pain of losing is psychologically twice as powerful as the pleasure of gaining. The loss felt from money or any other valuable object can feel worse than gaining that same thing.
Loss aversion is widespread in our everyday lives when dealing with financial decisions and marketing. Notably, loss aversion gets stronger in individuals as the stakes of their choice grow larger.
Why Does Loss Aversion Happen?
A mixture of our neurological makeup, socioeconomic factors, and cultural background causes loss aversion.
Our brains
Three specific regions of the human brain become activated in situations involving loss aversion.
The Amygdala is the part of our brain which processes fear. It creates an automated sense of anxiety when we see a snake or a tiger. The reaction we experience with loss in this part of our brain is similar to our brain’s response when we react to such anxieties.
The second region in our brain that is active when we process a loss is the Striatum. The striatum shows activity when we experience both losses and their equivalent gains, but it lights up more for the losses.
Finally, our brain’s Insula area reacts to disgust and works with the amygdala to make individuals avoid certain types of behaviour. Neuroscientists have noted that the insula region lights up when responding to a loss. The higher the prospect of loss, the more activated the insula becomes compared to an equivalent gain.1
Loss aversion is very common with retail investors. Whenever the stock held by them falls, they are simply not willing to book that loss as it's very PAINFUL.
This LOSS AVERSION then leads to many other biases. I am trying to list a few
Endowment Bias - Though the stock is falling, it's my stock, so it’s precioussss… And the market doesn't know its true potential. So I won't sell it at a loss.
Commitment Bias - Though the stock is at a loss, as I have committed to it, I can't sell it.
Sunk Cost Fallacy - When loss aversion is combined with other biases like the commitment bias/endowment bias/authority bias can lead to sunk cost fallacy. So here the investor keeps on averaging the stock down. And eventually, sell at a huge loss.
(Due to loss aversion) As we are not ready to sell our losers, we end up selling our winners. And so lose the powerful effect of LONG TEM COMPOUNDING.
One more important concept to keep in mind when dealing with loss aversion is the - Opportunity cost. A loss of 50% requires a gain of 100% just to break even.
Loss aversion is also commonly seen in property / real estate investments. Investors refuse to sell their property at a loss and hold on it to it hoping the investment will turn profitable someday. Throughout the holding period of the investment, they pay interest on their loans which could have been avoided if they sold earlier.
Well, how do you guard against the loss aversion bias?
Here we can borrow the concept of STOP-LOSS from trading into investing. One practical step is to always use firm stop-loss orders to minimise your potential loss in any stock. That kind of pre-commitment to always limit your risk helps to mitigate loss aversion.
I use a stop-loss of 20% in all the stock that I hold. How much ever you study the company and even if it's in your circle of competence, there are many things we retailers can't know. So if any stock falls by 20% is a sell. This way the stock is out of my mind ( stop bothering me ) and have more free capital to deploy in another interesting idea.
But otherwise, for any loss-making investment, start by asking the following questions:
If this investment was not a part of my portfolio, would I still consider purchasing this today afresh?
Are the underlying fundamentals of the asset intact?
Are the prospects of the asset positive?
If the answer to any questions is NO, then realizing the loss sooner than later may be wise.
So as with all the investing biases, one of the main remedies is to Write an Investment Diary. Here you should write all thesis / anti-thesis for your stock ideas. The gains / the losses that you have made and the reasons behind them. It's better to keep this Investment Diary in digital format, as it's easier to search and always available online. I use Google Docs for writing my investment diary and have been maintaining it since 2013.
Hope you enjoyed this blog on oss Aversion.
Please do like and share it.
Regards,
dr.vikas.
1 - https://thedecisionlab.com/biases/loss-aversion