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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