Loss Aversion: Understanding the Psychology of Financial Decisions

Loss aversion is a tendency in behavioral financeBehavioral FinanceBehavioral finance is the study of the influence of psychology on the behavior of investors or financial practitioners. It also includes the subsequent effects on the markets. It focuses on the fact that investors are not always rational where investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains. The more one experiences losses, the more likely they are to become prone to loss aversion.

Research on loss aversion shows that investors feel the pain of a loss more than twice as strongly as they feel the enjoyment of making a profit.

Selling Winners and Holding Losers

Many investors don’t acknowledge a loss as being such until it is realized. Therefore, to avoid experiencing the pain of a “real” loss, they will continue to hold onto an investment even as their losses from it increase. This is because they can avoid psychologically or emotionally facing the fact of their loss as long as they haven’t yet closed out the trade. In their subconscious, if not their conscious, thinking, the loss doesn’t “count” until the investment is closed. The negative effect of this, of course, is that investors often continue to hold onto losing investments much longer than they should and end up suffering much bigger losses than necessary. That’s what loss aversion looks like in practice.

Well, how do you guard against the loss aversion bias? One practical step is to always use firm stop-loss orders to minimize your potential loss in any trade. That kind of pre-commitment to always limiting your risk helps to mitigate the tendency to fall into a loss aversion trap.

Examples of Loss Aversion

Below is a list of loss aversion examples that investors often fall into:

• Investing in low-return, guaranteed investments over more promising investments that carry higher risk
• Not selling a stock that you hold when your current rational analysis of the stock clearly indicates that it should be abandoned as an investment
• Selling a stock that has gone up slightly in price just to realize a gain of any amount, when your analysis indicates that the stock should be held longer for a much larger profit
• Telling oneself that an investment is not a loss until it’s realized (i.e., when the investment is sold)

Rational Strategies for Avoiding Losses

Let’s look at some examples of how a company or an individual can reasonably minimize risk exposure and losses:

• Hedge an existing investment by making a second investment that’s inversely correlated to the first investment
• Invest in insurance products that have a guaranteed rate of returnRate of ReturnThe Rate of Return (ROR) is the gain or loss of an investment over a period of time copmared to the initial cost of the investment expressed as a percentage. This guide teaches the most common formulas
• Invest in government bondsBondsBonds are fixed-income securities that are issued by corporations and governments to raise capital. The bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed (or variable) interest rate for a specified period.
• Purchase investments with relatively low price volatility
• Consciously remain aware of loss aversion as a potential weakness in your investing decisions
• Invest in companies that have an extremely strong balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. The financial statements are key to both financial modeling and accounting. and cash flow generation. (In other words, perform due diligence and only make investments that rational analysis indicates have genuine potential to significantly increase in value.)

Additional Resources

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To learn more and advance your career, these guides will be helpful:

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