Loss Aversion- How it Can Ruin Your Investments?
Loss Aversion: If I ask you to play a coin toss game with me where you’ll get Rs 1,000 if you win, however, you’ll have to give me Rs 1,000 if you lose, will you play the game?
It’s a fair game. Right? You have an equal chance to win Rs 1,000.
However, if you are like most of us, you won’t play this game.
What if I changed the rule a little? If you win, you’ll get Rs 1,200 and if you lose the amount to pay will be the same i.e. Rs 1,000. Will you play now?
No?… Okay. Last chance.
If you win, you’ll get Rs 1,500 and if you lose- pay just Rs 1,000. Should we start the game?
For the majority of the population, until the amount that they could win is at least twice as large as the amount they could lose, they won’t play the game.
People prefer avoiding losses to acquiring equivalent gains. In technical terms, this is known as ‘loss aversion’. Here, the perceived value of the loss is considered more significant compared to the perceived value of gain even if the amount in both these cases is equivalent.
“Losses loom larger than gains.”
In the above example, loss aversion implies that the person who loses Rs 1,000 will lose more satisfaction than another person’s gain satisfaction from a win of Rs 1,000.
Psychologically, the pain of losing is about twice as powerful as the pleasure of gaining. (And maybe that’s why ‘penalties’ are sometimes more effective in motivating people than rewards).
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A few examples of loss aversion in the stock market:
There are many examples in the stock market where we can notice the effect on loss aversion controlling the investing instincts of the investors. Few of the top ones are given below:
- Investing in safe options like FD with a lower return (say 7.5%) even though better alternatives with higher yields (12-15%) are available like mutual funds.
- Selling a good stock just because its price is higher than what you paid and to lock in quick profits.
- Not willing to sell your loser stock below the buying price because you do not want to take a loss.
NOTE: Most mutual fund companies and fund managers know the concept of ‘risk-aversion’. That’s why, most of these funds have a tagline like – “Get a double return than your savings”, just to attract the customers. Even if that fund is not performing well compared to the market, many people will opt into those funds because of the tagline. Do not get trapped in wrong mutual funds.
What is the cure for loss aversion?
Loss aversion is the default mode of most people, including investors. And unfortunately, this cannot be fixed quickly. Losing sucks and as humans, we don’t like it, and it results in many investing problems.
However, if you do not want to lose different opportunities to make money, then you need to get over this syndrome. There’s no hard and fast rule of how to get over loss aversion syndrome. Nonetheless, being aware might help a little.
Now that you know this syndrome take account of this factor whenever you’re making an investment decision. With time and practice, risk aversion syndrome can be controlled.
Losses and gains are valued differently. People make their decisions based on the perceived value of the loss and gains. It’s human instincts, and most people behave similarly. Therefore, it’s okay if you also used to act the same.
However, now that you have learned this concept, you need to understand that loss aversion manifests itself as an unwillingness to take a loss. It’s tough to take a loss and sell your losing stock. However, it’s necessary to take control of your emotions. Do not let loss aversion rob yourself of the potential for a better future.
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Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting