Behavioral Finance FE 3

Tu. Th. (11:30-1:00 PM)

Prof.: Sir Cesar Abasolo
Reporters: Janice Rodriguez and Christine Joy Rodriguez

LOSS AVERSION BIAS

Loss aversion is a cognitive bias that describes why, for individuals, 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 refers to an
individual’s tendency to prefer avoiding losses to acquiring equivalent gains. Loss aversion is
common in cognitive psychology, decision theory, and behavioral economics. In our everyday
lives, loss aversion is especially common when individuals deal with financial decisions and
marketing. An individual is less likely to buy a stock if it’s seen as risky with the potential for a
loss of money, even though the reward potential is high. Notably, loss aversion gets stronger in
individuals as the stakes of their choice grow larger.

What is loss aversion bias?

● It is the tendency to avoid losses over achieving equivalent gains.
● In behavioral economics it refers to a phenomenon where a real or potential loss is
perceived by individuals as psychologically or emotionally more severe than an equivalent gain.

PROSPECT THEORY
EXAMPLE SITUATIONS:

INVESTOR # 1

Jose buy a stock for 100,000, but then the shares fall by 10%. He is sitting on a loss.

INVESTOR #2

Karen invest 100,000 in a stock market and as soon as it rises slightly, Karen book her profit and exit
the investment.

IMPLICATIONS TO INVESTORS:

INVESTOR # 1

● Loss aversion may cause investors to hold on to loss making stocks or funds for very long period. They
refuse to sell a stock or fund at a loss and can hold on it for long periods of time till the loss is recovered.

Ex. I went to a casino to gamble, with a capital of 100,000. My 100,000 became 200,00 and suddenly it
became 100,000 again which is my starting capital. So because in my mind I thought that I lost 100,000
which is I didn’t have in the first place. I chose to stay on the hope that I would get to recover that
100,000 I won earlier and as the time pass by all my money were suddenly gone. If only I leave the
casino when I still have my 100,00 capital, I wouln’t loss that remaining money in my hand.

● A long time may elapsed and the return on the investment is very low.

Ex. I have a house in Baguio, but because my work is in Manila, I need to stay in Manila. My cousin
suggest me to sell my house in Baguio but I refused to do so because it has a sentimental value for me. I
bought that house using my salary that I saved. But because I’m working in Manila, I didn’t notice that it
has many damages that is needed to be repaired and it’s value deppreciated. If I sell that house in the
first place I wouldn’t lose much, and I won’t have to spend a lot of money in repairing damages of the
house.

INVESTOR # 2

● They are driven by the need to appear to be a success and can’t risk being seen as a failure.

Ex. Jose invested 100,000 in a company of gasoline, and his investment rise by 10 % in knowing that it
already has a gain. Jose booked the investment in a thought that what if it suddenly drops. He doesn’t
want the thought of losing.

● Obviously, if profits are booked too early, then the investors lose out on opportunities.

Ex. After Jose booked his profits too early, the investment continuously rise. And Jose loss the
opportunty of gaining mor money from his investment.
ADVICE TO INVESTORS:

INVESTOR # 1

● They can avoid loss aversion by not getting too emotionally involved in their investments.

Ex. “If I gave you a nice house and lamborghini, put a million dollars in your bank account, and provided
you with a social network,then, a few months later, took everything away, you would be much worse off
than if nothing had happened in the first place”

~ Nassim Nicholas Taleb

● They should have a rational and objective portfolio performance evaluation process.

● They should do what is right to meet their financial goals including selling funds that are
underperforming consistently and switching to better funds.

● They should adopt a strategic asset allocation strategy, thinking rationally and learning to build
diversified portfolios and using buy and hold strategies.

INVESTOR # 2

● Avoid overthinking about the market, as it goes where it wants to go and best bet for anyone
should be to try and go with it.
● The best decision is to do absolutely nothing and sit tight as long as the stock is getting good
returns. There is no need to be in a hurry to book profit.
● Follow the simple rule, which is to follow the market and not try to predict it to remain on the
right side of every trade.
● Take advantage of the rising of price to earn wealthy returns.

CONCLUSION
No one likes to make a loss, but loss aversion can cause you to lose more money or make less
money than what you feared to lose. There are risk involved in investments, many of these risks
are beyond your control and you cannot be right all the time. Sometimes it is better to book a
loss and move on to alternative investment options. It is difficult to separate emotions from
investing, but successful investors are able to do it. A good financial advisor can help you
overcome this behavioral bias.