What Is Loss Aversion? How It Affects Decision Making Process?

By: Rupesh Oli

Introduction

Loss aversion, one of the vital concepts in behavioral finance, refers to the tendency of investors to not value the gain and loss in the same manner. When it comes to decision making, s/he takes the gain associated with the investment into high consideration rather than the loss with a prime motto to avoid the risk linked to the loss. In short, loss aversion simply could be understood as a psychological bias that reflects the pessimism of an investor. The research that falls under the domain of loss aversion suggests, losses are twice as powerful as gains implying the pain of losing in the financial market is twice as powerful as the joy of gaining. For instance, when you compare the satisfaction, a person gains from winning $100 in the market with the loss of satisfaction from losing $100, it is the fact that the second scenario outweighs the first one, as per the theory of Loss Aversion. It is because s/he will lose more satisfaction during the losses if compared to the gain of satisfaction when gaining the same amount of capital s/he had lost previously.

It is the impact of loss aversion due to which investors become so fearful of the losses, so they focus more on averting a loss rather than making the equivalent gains. The likelihood of the investors becoming prone to loss aversion increases when they experience frequent losses compared to their gain or profit in the market. When it comes to rational investment decisions, loss aversion can be considered as one of the major hindrances. As the majority of investors innate aversion to losses, it deeply impacts the psychology of people investing in the stock market. It prevents many people from making logical decisions as the fear of loss invades them deeply.

Loss aversion is a particular case of risk aversion. As per Shiller (1998), it is the human tendency to feel the pain of regret when making errors, no matter it be the small one, and for which they hope to avoid the regret pain. Aftalion (2002), proposed an instance where he illustrated the regret aversion: “Paul owns shares of firm A. During the previous year, he had thought of selling them to buy shares of firm B but had renounced his idea. If he had pursued, he would have earned $20,000. Georgette owned shares of firm B, which she sold them to buy shares of firm A. If she had kept shares of firm B, she would have been richer by $20,000”.

In this particular example, Paul, the first investor, is loss-averse as he does not want to sell. On the other hand, Georgette, the second investor, has already sold, hence, is not subject to loss aversion. Aftalion (2002) stated that the majority of us consider that the second investor normally must be less happy. Further, it can also be seen, the impact of the losses on the investor’s behavior, mentally, is more significant than the impact of gain, characterizes the loss aversion, and justifies the pessimism of the investor subjected to these emotional biases when it comes to investing. As a result, investors are much more sensitive to the losses and they, most of the time, seek to avoid it influencing their decision-making ability. In the stock market too, the winning stocks are sold more heftily than the losing ones, which expresses the fear and sentiment of loss among the investors.

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How Loss Aversion Influences Decision Making In Investing/Trading?

Loss Aversion, in several ways, influences our decision-making when it comes to investing or trading in the stock market, as listed below.

It is primarily due to loss aversion investors tend to hold on to loss-making stocks for the long haul. Hence, they refuse to sell the stocks on loss that they acquire and disregard the better alternatives which ultimately deprive them of investing in other stocks that they could have put on their portfolio.

If taken a look at the scenario from another perspective, when the investors hold on to loss-making stocks for a long period of time, eventually, they discover that they made a hefty loss considering their unwillingness to sell at previous phases of the downturn in the market. As a result, they sell the stocks at a higher loss than they would have incurred if decided to sell earlier. As a matter of fact, they worsen their portfolio embracing hefty losses which could have been easily sorted out earlier.

One of the very popular sectors where loss aversion is dominant is the real investment sector. Investors deny selling their property at a loss and hold it in the hope of its recovery that their investment will turn profitable in the coming days. They continuously pay the interest amount on their loans throughout the holding period which could have been avoided if sold earlier figuring the right time to exit.

As an individual, we deal with the financial aspect on a day-to-day basis managing our income and expenses, figuring out where to spend and where not to. Hence, such modest yet impactful financial decisions we take possess a huge capability of making or breaking our habits of managing the capital we own. However, due to the impact of loss aversion, most of the time, we fail to take calculated and sound financial decisions, whose impact would be detrimental in the long run.

Investors when investing in a stock and once it rises slightly, tend to book the profits and exit. It implies that if they find a winner in the market, they lack the perseverance to let it reach its full potential. When profits are booked early, the investors lose out on significant opportunities they would otherwise have leveraged if they tried to control their innate loss aversion. When the stocks depict a downtrend as well, they are unable to think rationally, due to which they avoid fruitful decisions like stop loss at that specific point of time.

In the hope of stock’s recovery, investors hold on to stocks for too long no matter the fact it takes much more time to regain the same position it previously had on the market. For instance, let’s suppose you bought the stocks for $1000 and ignored the uptrend and downtrend in the market. What if, the stocks went through a rigorous downtrend and just recovered in the market, and you managed to sell it at $1011 after one year. If so, what’s your return? It’s only 1.1%. What is the reason behind such a minimal return? It is only because of the stop-loss order you failed to execute on the stocks you bought. You were so fearful of the losses that you were not able to enjoy the standard profit margin as you preferred avoiding the losses going on, as your prior preference.

To play safe, the majority of young investors who might possess a high-risk appetite, avoid any sort of investing in the equity market. Instead, they prefer their capital invested in fixed income securities such as FD and bonds. There is nothing wrong with this, however, they miss the perfect opportunity to learn much more and leverage exponentially from the equity market especially if they start from such a young age.

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How to Avoid Loss Aversion?

Loss aversion showcases the biasing effect whereas loss attention, on the other hand, has a debiasing effect. Hence, whenever investors get the gut feeling that they are trying to do something below the mark due to the impact of loss aversion, they can try their best to switch towards loss attention, which refers to the individuals’ tendency to pay more attention to the circumstances where higher loss is involved rather than focusing on settings where zero to minimal losses are involved. Investors can hedge their current investment by making a second investment inversely proportional to the first investment. For instance, when the stock market is delivering a terrible run, investors can prefer commodity trading, for instance, Gold. Investors can further handpick the companies with strong fundamentals instead of performing the random investment following what the horde is doing in the market. They can analyze income statements, balance sheets, cash flow statements, and financial ratios and filter out the companies. If done so, such companies possess a very minimal chance of disappointing their stockholders, even if they do not sell the stocks during the downtrend of the market.

Another strategy that an investor can follow is, ignoring the financial media as much as possible as they focus more on the dramatic ups and downs in the market rather than providing the metrics of how the market is going to perform in the longer time horizon. Instead, s/he can rely on trusted websites and financial portals to evaluate the market in terms of numbers and the technical indicators trying to analyze trends and patterns on their own. If done so, you would definitely not be taking any sort of irrational decisions from the fear of creating short-term decisions that might lead towards permanent capital loss. If you can afford, a good financial advisor would be the way to go. Last but not least, instead of ignoring loss aversion on a time-to-time basis, just embrace it. Accept the fact that loss aversion prevails and try to pinpoint the instances when it could lead towards poor financial decisions, which would ultimately assist in figuring out your weakness and where you lack in terms of handling the loss aversion.

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What Some of the Research Papers Have to Say?

In the research paper entitled ‘Loss aversion, overconfidence of investors and their impact on market performance evidence from the US stock markets’ published under Journal of Economics, Finance and Administrative Science in 2018, authors Ahmed Bouteska and Boutheina Regaieg made a revelation that companies’ performance in the US financial markets as measured by the economic and market performance is significantly influenced by two behavioral biases namely, loss aversion and overconfidence whereby investors’ pessimism reflecting loss aversion negatively impacts the economic performance of the US companies, whereas, investors’ optimism showcasing overconfidence positively impacts the stock market performance of these companies. Hence, the research concludes through its implication by stating overconfident investors may benefit the shareholders through higher stock returns, lower risk, and greater profitability; however, the loss aversion may reflect the exact opposite effect.

Further, the research paper entitled ‘Loss Aversion in Financial Markets’ authored by Liyan Yang published under Journal of Mechanism and Institutional Design in 2019 came up with some vital concluding remarks. It revealed that loss aversion impacts the financial markets based on changing market investors’ risk attitude as loss aversion makes investors risk-averse on both global and the local scale, and the risk attitudes they provoke vary as per their prior gains or losses. Some of the economists even showcased that monkeys too exhibit loss aversion, meaning, loss aversion is indeed a biological reaction, which might be the result of evolution. However, the author too stated the necessity of further research in order to advance the understanding underlying the dimension of loss aversion.

The Bottom Line

Loss Aversion is one of the major investment biases that could prove to be really detrimental to one’s wealth. Hence, the proper understanding of such bias is crucial. As an investor, you cannot be right all the time. Sometimes, booking a loss and moving towards the best alternative investment options available could be the preferred way to go, however, the hold strategy could work out considering the fact the market could even show positive signals from the next day onwards. Hence, instead of perfectly timing your investment decisions, try to analyze what works best in the contemporary context. As an investor, you ought to have a rational financial goal and the strategy to switch to alternative investment options when your acquired financial assets are underperforming consistently and failing to deliver up to the mark. As human beings, we all have the psychological fear of losing the money we own, however, performing no action at all just for the sake of avoiding such fear in underwhelming circumstances would not be the path to adopt if we really want to execute our rational investment decision-making ability in the market. Therefore, being aware of it helps us manage our emotions to a certain extent which in turn can really leverage us with superior returns.

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