Loss Aversion

"I don't like losses, sport. Nothing ruins my day more than losses."
--Gordon Gekko (Wall Street)

Investors are subject to various biases that can cloud decision-making processes. One of these biases is 'loss aversion.' A concept developed by by behavioral psychologists Daniel Kahneman and Amos Tversky (1979) as part of their Nobel-winning research on 'prospect theory,' loss aversion means we tend to overweight losses compared to gains.

In customer service settings, it is well known that when customers are dissatisfied they tend to share their negative experiences with others at far greater rates than when they are pleasantly surprised by the quality of service that they receive.

When we invest, the effect is similar. when we buy a stock and the investment goes down by, say, $10, we tend to feel more 'psychic pain' than if the stock goes up by that same $10 amount.

Because 'losses loom larger than gains' in our minds, Kahneman and Tversky (1979) found that this bias may drive us toward ill-advised investment behavior. For example, when we realize losses on an investment, we may be more willing to stick with that losing position longer than we should. In fact, we may be anxious to buy more--to 'double down'--so that we might at least get back to even on our original position.

Stated differently, we may be willing to make a bad situation worse by taking even more risk in order to 'save face.'

On the other hand, when we realize gains, we are often prone to sell our winning positions too soon in order to 'lock in gains' before they might turn into losses.

Professional gamblers will tell you that this is precisely the opposite of what they do when putting money at risk in casinos. When you are ahead, that is the time to push your bets because you are 'playing with the house's money.' Conversely, when you are behind, that is the time to consider reducing your risky exposure in order to 'cut your losses.'

While casinos do not present quite the same environment as financial markets, hopefully you can see the implications that loss aversion brings to investing. How we manage winning and losing investment positions is likely to be influenced by a bias toward trying to turn losing positions around at the expense of gains.

Being aware of the negative effects that loss aversion presents is a good first step toward managing this bias in our decision-making processes.

Reference

Kahneman, D. & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47: 263-291.