What is loss aversion and how to deal with it!

Nobody likes losing money. Studies show that we feel losses twice as intensely as gains, as Daniel Kahneman and Amos Tversky said in 1979, “losses are more tragic than gains”. In other words, if we lose $100, we feel that loss more strongly than a gain of $100. This behavior is called “loss aversion” and it is driven by the way we humans make decisions. It's not our fault, it's just in our nature.

It is not the same as risk aversion

Loss aversion differs from risk aversion, i.e. the tendency of people to prefer low uncertainty outcomes to high uncertainty outcomes, even though in the second case the average outcome is equal or superior in terms of monetary value to the result obtained in the first. 

“It's not really that people don't like to take risks,” says Dan Kemp, director of global investments at Morningstar Investment Management. “What people don't like is losing something. We suffer from loss aversion and you know what I'm talking about if you've ever frequented a casino. At the start of the evening, people tend to bet their chips at the roulette table very carefully, avoiding losing their money too quickly. But at the end of the night, when they only have a few chips left in their pocket, they tend to make riskier bets. So people who were risk-averse at the start of the evening when they had a lot of money in their pockets become risk-averse when they've lost that money because they're trying to recoup their losses.

Loss aversion can harm you

Investors have been shown to be more likely to sell winning stocks in an effort to “book profits”, while not wanting to accept defeat in the event of large losses. When people see that a stock or a fund is going downhill, they feel the need to limit the damage. This may lead them to sell investments that have barely lost value. But similarly, if they lose large amounts of money, they are normally very inclined to hang on to their stock or fund. They don't want to sell at this point, hoping they will recoup their starting value. This is why loss aversion can really hurt investors, not only when they take small losses, but also when they refuse to take big losses. Philip Fisher, American stock investor and famous author of Common Stocks and Uncommon Profits, wrote: There is no other single reason why investors have lost more money than by keeping security they didn't want in the hope that they could sell it and at least cover their costs.  

Differentiate bad decisions from bad results

Regret also plays a role in loss aversion. It can cause us to not be able to distinguish between a bad decision and a bad outcome. We regret a poor result, such as a series of weak returns from particular security, even if we had chosen this investment for all the right reasons. In this case, regret can cause us to make a bad sell decision, such as liquidating a strong company when it bottoms out instead of increasing our stake there.

How to cope

There are ways to avoid bad decisions. Dan Kemp suggests that one of the best things to do is stop looking at your portfolio. The more you look at your portfolio and the more likely you are to be aware of the ups and downs, the more likely you are to get trapped into loss aversion. “If you have a good strategy, are a former advisor, have diligently put together a strategy yourself, or someone else is managing your portfolio, stop looking at it so often,” says -he. “You have to engage in periodic reviews. It's only natural to want to make sure that the person handling your money is appropriate, or that the risk associated with the funds in which you invest is adequate.