Loss Aversion

What Is Loss Aversion?

Loss aversion in behavioral economics refers to a phenomenon where a real or
potential loss is perceived by individuals as psychologically or emotionally more
severe than an equivalent gain. For instance, the pain of losing $100 is often far
greater than the joy gained in finding the same amount.

The psychological effects of experiencing a loss or even facing the possibility of a

loss might even induce risk-taking behavior that could make realized losses even
more likely or more severe.

KEY TAKEAWAYS

 Loss aversion is the observation that human beings experience losses

asymmetrically more severely than equivalent gains.
 This overwhelming fear of loss can cause investors to behave irrationally
and make bad decisions, such as holding onto a stock for too long or too
little time.
 Investors can avoid psychological traps by adopting a strategic
asset allocation strategy, thinking rationally, and not letting emotion get the
better of them.
Understanding Loss Aversion
Nobody likes to lose, especially when it could result in losing money. The fear of
realizing a loss can cripple an investor, prompting him or her to hold onto a losing
investment long after it should have been sold or to offload winning stocks too
soon—a cognitive bias known as the disposition effect. Rookies often make the
mistake of hoping a stock will bounce back, against all evidence to the contrary,
because losses lead to more extreme emotional responses than gains.

Behavioral economists claim that humans are wired for loss aversion, one of
many cognitive biases identified by. Some psychological studies suggest that the
pain of losing is psychologically about twice as powerful as the joy we experience
when winning. However, several studies also call into question the practical
effect or even the existence of loss aversion. Nonetheless, it may be possible
that overwhelming fear can cause investors to behave irrationally and make poor
investment decisions.

Loss psychology may even be the cause of the asymmetric volatility

phenomenon exhibited in stock markets, where equity market volatility is higher
in declining markets than in rising ones. According to prospect theory, people
strongly prefer avoiding losses than they do acquiring gains.
This loss aversion is so strong that it can lead to negativity bias. In such
cases, investors put more weight on bad news than on good news, causing them
to miss out on bull markets—for fear that they will reverse course—and panic
when markets sell-off.

Minimizing Loss Aversion

One way of avoiding psychological traps is to follow a strategic asset
allocation strategy. Rather than trying to perfectly time market sentiment, and
abide by the old adage of letting your winners run, investors are advised
to rebalance portfolios periodically, according to a rules-based methodology.

Formula investing is another form of strategic investment. For example, constant

ratio plans keep the aggressive and conservative portions of a portfolio set at a
fixed ratio. To maintain the target weights—typically of stocks and bonds—the
portfolio is periodically rebalanced by selling outperforming assets and buying
underperforming ones. This runs counter to momentum investing, which is pro-
cyclical.

There are many tried and tested principles for asset allocation and fund
management, such as learning to build diversified portfolios and using buy and
hold strategies. Another systematic way of investing is employing smart
beta strategies, such as equal weight portfolios, to avoid market inefficiencies
that creep into index investing due to the reliance on market capitalization. Factor
investing can also be used to mitigate such market risk factors.

Some Upside to Loss Psychology

Behavioral finance provides scientific insights into our cognitive reasoning and
investment decisions; at a collective level, it helps us understand
why bubbles and market panics might occur. Investors need to understand
behavioral finance, not only to be able to capitalize on stock and bond market
fluctuations, but also to be more aware of their own decision-making process.

Losses can have a value if you learn from them and look at things
dispassionately and strategically. Losses are inevitable, which is why successful
investors incorporate "loss psychology" into their investment strategies and
use coping strategies.

To break free from their fear of financial losses and overcome cognitive biases,
they learn to handle negative experiences and avoid making emotionally-based,
panic-driven decisions. Smart investors focus on rational and prudent trading
strategies, preventing them from falling into the common traps that arise when
psychology and emotions affect judgments.
Frequently Asked Questions
Why do losses loom larger than gains?
There are several possible explanations for loss aversion. Psychologists point to
how our brains are wired and that over the course of our evolutionary history,
protecting against losses has been more advantageous for survival than seeking
gains. Sociologists point to the fact that we are socially conditioned to fear losing,
in everything from monetary losses but also in competitive activities like sports
and games to being rejected by a date.

How can loss aversion explain increased risk-taking behavior?

Rather than deal with the psychological pain of actually locking in a loss and
realizing it, those with paper losses may be inclined to take on even greater risk
in hopes of breaking even - for instance, doubling-down at the casino when
experiencing a bout of bad luck.

Is everybody loss averse?

Human beings tend to be loss averse; however, different people display different
levels of loss aversion. Research has shown, for example, that people trained as
economists or who are professional traders tend to exhibit, on average, lower
levels of loss aversion than others.1 2

How is loss aversion different from risk aversion?

Everybody has a unique risk tolerance. This is based on personal circumstances
like assets and income, as well as investment time horizon (e.g. time until
retirement), age, and other demographic characteristics. People who are more
risk-averse will take on less risk than those who are risk-seeking. Risk aversion,
however, is completely rational since both losses and gains at any level of risk-
taking would be viewed symmetrically. It is the asymmetry of loss aversion where
losses loom larger than gains - at any level of risk tolerance - that is irrational and
problematic.