One of the key things I learned early on is just how emotional investments can be, and if you are new to investing you should brace yourself. If you act on your emotions when investing, you are increasing the risk of making poor investment decisions. Loss aversion is one of these key emotional states and refers to the fear of losing something.
Think for a moment about the visceral sting you feel when you see a stock you have invested in start to plummet. Now, consider the euphoria when the opposite happens – your stock is soaring.
Which of the two scenarios provoke the strongest emotional feeling? The contrast between these scenarios is striking and reveals a psychological trait that, if not controlled, can significantly influence your investment decisions.
What is loss aversion?
At its core, loss aversion refers to the tendency for people to prefer avoiding losses rather than acquiring equivalent gains. In the context of investing, it means that the pain of losing money often feels twice as intense as the joy of gaining the same amount. Behavioral economists Daniel Kahneman and Amos Tversky were the first to popularize this concept in the late 1970s.
Let us consider a hypothetical scenario: If you were given the choice between receiving $50 guaranteed or having a 50% chance of winning $100, which would you choose? According to studies, most people would choose the guaranteed $50, as the prospect of potentially ending up with nothing is too painful. In effect this is a bias towards avoiding losses.
Loss aversion and the stock market
In the stock market loss aversion manifests itself in a couple of notable ways:
1. Not entering the stock market
Loss aversion can discourage potential investors from entering the stock market. The fear of potential losses often outweighs the prospect of gains, causing hesitation and sometimes leading to missed opportunities due to over-analysis or avoidance of perceived risk.
2. Holding on to losing stocks for too long
Investors often hold on to poorly performing stocks in the hope that they will rebound, refusing to sell and “lock in” the loss. This is often despite clear signs that the stock may not recover.
3. Selling winning stocks too soon
Conversely, investors frequently sell their winning stocks too early to secure a gain, out of fear that they could lose their accumulated profits if the stock price drops.
How to deal with loss aversion
Stick to your investment strategy
Having a clear strategy helps to remove emotion from your investment decisions. This could involve setting rules for when you will sell a stock, both at a loss and a gain.
The first time I invested heavily in a stock it proceeded to decline by 30% the following weeks. As devasting as that was to behold as a novice investor, I held my position, because I knew why I bought that stock, and I was confident in the future value of the stock. I ended up earning a return on my investment.
Learn how to create your own investment strategy and stick to it.
Embrace a long-term perspective
Investing is not about immediate gratification. Adopting a long-term perspective enables you to ride out the inevitable ups and downs of the market. Patience is a virtue in investing, as demonstrated by successful investors like Warren Buffett and Charlie Munger.
Diversify your investments
A diversified portfolio can help minimize the risk of significant losses, and reduce the potential for loss aversion to kick in. By spreading your investments across a variety of asset classes and sectors, you’re less likely to experience sharp declines in your portfolio’s value.
Learn how to diversify your portfolio.
Conclusion
Loss aversion is part of being human, but it doesn’t have to rule your investments. Remember, even the big-shot investors lose money sometimes. What makes them successful is their patience, their ability to keep their cool, and their commitment to a long-term plan.
