Loss aversion bias

Investors are often far more interested and consumed with the daily movements of stocks and the possibility of placing a winning trade than sitting down and understanding how our brains work and how this undermines our performance in the market.

 

One of the most common errors identified by psychologists and behavioural finance studies is that investors always tend to have a bias against losing money. Unfortunately humans fear losses more than we appreciate gains. This was confirmed in a simple university survey using a coin toss whereby the participants would need an average payoff of $40 on a winning toss to offset the pain of taking a potential loss of $20 on a losing toss. In other words, the pain of a loss is twice as potent as the pleasure generated by a gain.

 

As advisers, the above result demonstrates the reason we have more trouble getting clients to sell a losing position, even when clients also believe the position is likely to continue its loss for quite some time, in the hope that they recover. Many times, this recovery rarely takes place, particularly with small speculative companies with no profits.

 

This fear of loss and negativity bias may in fact blind an investor to take advantage of good opportunities. It is often important to weigh up the prospect of loss with that of the opportunity costs. It may also mean that the portfolio struggles to outperform over time, as this loss aversion bias leads to having too many losers being kept and too many winners being sold (often too early).

 

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Paradigm on investments

Image thanks to RambergMediaImages

Following our recent paper titled "Portfolio paradigm", please refer to this recent AFR article which provides further evidence that there is a paradigm on investments.

This blog is brought to you by Financial Decisions, a leading financial planning firm offering a diverse range of services that include investments and superannuation, personal insurance, estate planning, mortgages, tax planning and family office. Please call us today and take control of your financial future.

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Investing is a game of expectations

Have you ever wondered why a good earnings result is sometimes met by a drop in the share price? Or maybe why stocks rise even after poor economic data has been announced to the public?

There are many instances where it is hard to explain the daily movements of shares due to the contradiction between news and price. In our opinion, these unexpected movements are directly related to human behaviour and the expectations investors have in relation to a certain company or event.

Traders and investors buy and sell based on what they believe future news will be, whether that is tomorrow or next month. So when investors are nervous and cautious about the earnings of a company, they lower their expectations and have a tendency to sell prior to the earnings announcement.

If the earnings are not as bad as they originally feared, shares are inclined to increase as investors buy the stock back.

When the Global Financial Crisis hit top gear in the early part of 2009, the markets started to rise much earlier than the economy, as expectations of an improving economy in the latter part of 2009 caused investors to buy stocks again. By the time the economy had shown signs of improvement, many markets around the world had risen approximately 50%.

This blog is brought to you by Financial Decisions, a leading financial planning firm offering a diverse range of services that include investments and superannuation, personal insurance, estate planning, mortgages, tax planning and family office.  Please call us today and take control of your financial future.

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