How to Deal With Loss Aversion

Investors feel losses more keenly than gains. Luckily, we have some tips to avoid bad decisions

Sara Silano 9 December, 2021 | 2:16PM
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No one likes losing money. Studies show that we feel losses twice as keenly as we feel gains – as Daniel Kahneman and Amos Tversky said in 1979, “Losses loom larger than gains”. Put another way, if we lose £100, we feel that loss more than we’d get excited about winning £100. This behaviour is called "loss aversion", and it is driven by the way that we make decisions as human beings. It’s not our fault, but just the creatures that we are.

It’s not Risk Aversion

Loss aversion is different from risk aversion – that is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more certain outcome.

“The idea that people don’t like taking risks it’s not really true”, said Dan Kemp, global chief investment officer at Morningstar Investment Management. “What people don't like is losing things. We suffer from loss aversion, and you can see that if you ever go into a casino. When you go in at the start of the night, people tend to spend their chips at the roulette table very carefully and try and lose money as slowly as possible.

"But when they get to the end of the night, they just have a few chips left in their pocket, they tend to go for really high-risk bets. So, people move from being risk averse at the beginning of the evening when they have lots and then when they've lost that money, they become risk seeking because they're trying to get it back. We see exactly the same thing in investment.”.

Loss Aversion Can Hurt You

Investors have been shown to be more likely to sell winning stocks in an effort to "take some profits," while at the same time not wanting to accept defeat in the case of big losses. As people see a stock or a fund falling in price, they feel that they've got to stop losing money. And so that can lead to selling investments when there's just a small dip in prices. But equally, if they are losing large sums of money, then they are normally very keen to hang on to it. They don't want to sell the stock or the fund at that point, because they're hoping they will get back to the value that they started with. Therefore, loss aversion can really hurt investors, not only when they are taking small losses, but also when they are refusing to take big losses.

Philip Fisher, an American stock investor best known as the author of the book Common Stocks and Uncommon Profits, wrote that, “More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason.”

Bad Decisions vs Bad Outcomes

Regret also comes into play with loss aversion. It may lead us to be unable to distinguish between a bad decision and a bad outcome. We regret a bad outcome, such as a stretch of weak performance from a given stock, even if we chose the investment for all the right reasons. In this case, regret can lead us to make a bad sell decision, such as selling a solid company at a bottom instead of buying more.

How to Deal With It

We have some options for avoiding bad decisions. Kemp suggests that one of the most powerful things is just to stop looking at our portfolio. The more we look at our portfolio, the more we are likely to be aware of the upside and downside, and the more likely we are to be caught by loss aversion. “If you have a good strategy, whether you have worked as an adviser, or you put something together diligently yourself, or you have a portfolio that someone else is running, stop looking at it so frequently”, he said. “You have to review periodically. Of course, you want to make sure that the person is looking after your money or the risk of the funds you invest in is appropriate. But it’s much easier to make that assessment over a longer time period than over a short time period.”

 

 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Sara Silano

Sara Silano  is Editorial Manager for Morningstar Italy