Investor Psychology Series Chapter 2: Loss Aversion
Loss aversion can also manifest itself in the form of the ‘disposition effect’. This is the action where investors tend to sell winning positions and hold onto losing positions as crystalising a loss is seen as a poor outcome.
This directly contradicts some of the most famous investing theories.
Loss Aversion
Conventional market efficient theory states that there is a direct exchange between risk and return. The higher the associated investment risk, the greater the return. Market efficient assumes that investors seek the highest return for the level of risk they are willing to take.
However, behavioural finance shows that theory may not play out in real life.
Fear of Loss
Behavioural scientists Dan Kahneman and Amos Taversky found in their investor studies the ‘Prospect Theory: An Analysis of Decision under Risk’, that investors are far more sensitive to loss than to the risk-return. To put that another way, people would prefer to avoid loss rather than attaining an equivalent gain i.e., better not to lose $100 than to find $100.
Several studies have also found people consider losses more than twice as severely as potential gains of the same amount. This leads to investment behaviour where investors agree to a smaller, sure ‘event’ rather than risk a large ‘expense loss’ even if the risk of that costly event may be miniscule.
For example, when asked to choose between receiving a guaranteed $900 or taking a 90 per cent chance of winning $1000 (and a 10 per cent chance of winning nothing), most people avoid the risk and take the $900. This is despite the fact that the expected outcome is the same in both cases.
However, if the choice is between possibly losing $900 and taking a 90 per cent chance of losing $1000, most people would prefer the second option (with the 90 per cent chance of losing $1000) and consequently engaging in risk-seeking behaviour in hopes of avoiding loss.
The fear of loss is clearly a major emotional driver that is very hard to avoid.
Disposition Effect
One of the outcomes from the ‘fear of loss’ is hesitation which leads investors to hold on to losses for too long hoping for a recovery – known as the disposition effect.
The ‘disposition effect’ was coined by economists Hersh Shefrin and Meir Statman in their 1985 study into investor behaviour. They found investors had a tendency to sell winning positions and hold onto losing positions.
Professor Terrance Odean from Berkeley University took the disposition effect further in his study by looking at its detrimental effect on long term performance by following investors’ sold positions compared to their uncrystallised loss positions. The Odean study found that in the months and years after the sale of ‘winning’ investments, these investments continued to outperform the losing ones still in the portfolio, severely impacting overall investment performance.
What was also interesting from the Odean study was participants were both retail and professional investors yet both classes of participants did exactly the same thing across assets in that they sold early and held onto loss making positions in the hope of returning to neutral. This is a direct contradiction to theory and to the renowned investing rule, “Cut your losses early and let your winners run.”
Other Chapters:
https://www.investsmart.com.au/investment-news/investor-psychology-series-chapter-1-overcoming-the-bias-of-human-psychology/148972?qa=true
https://www.investsmart.com.au/investment-news/investor-psychology-series-chapter-3-heuristic-simplification-misuse-of-inform/149139
https://www.investsmart.com.au/investment-news/investor-psychology-series-chapter-4-the-human-psyche-and-diversification/149186
https://www.investsmart.com.au/investment-news/investor-psychology-series-chapter-5-cultural-bias-in-investing/149374
Frequently Asked Questions about this Article…
Loss aversion in investing refers to the tendency of investors to prefer avoiding losses rather than acquiring equivalent gains. This means that the pain of losing is felt more intensely than the pleasure of gaining, which can significantly influence investment decisions.
The disposition effect leads investors to sell winning positions too early and hold onto losing positions for too long, hoping for a recovery. This behavior can negatively impact long-term investment performance as winning investments often continue to outperform those that are held onto despite losses.
Investors often hold onto losing positions due to the fear of loss, hoping that these investments will recover. This hesitation is part of the disposition effect, where the emotional drive to avoid realizing a loss outweighs rational decision-making.
The Odean study revealed that both retail and professional investors tend to sell winning investments too early and hold onto losing ones. This behavior contradicts the investing rule of 'cutting your losses early and letting your winners run,' ultimately impacting overall investment performance.
Fear of loss influences investment choices by making investors more risk-averse. They often prefer a smaller, guaranteed gain over a potentially larger, uncertain one, even when the expected outcomes are the same. This can lead to conservative investment strategies that may not maximize returns.
Conventional market theory suggests a direct exchange between risk and return, meaning higher investment risks should lead to greater returns. However, behavioral finance indicates that real-life investor behavior often deviates from this theory due to psychological factors like loss aversion.
Investors might choose a guaranteed gain over a risky one due to loss aversion. The emotional impact of potentially losing is often stronger than the satisfaction of a possible gain, leading investors to opt for certainty even when the expected value of the risky option is the same.
Understanding loss aversion can improve investment strategies by helping investors recognize their biases and make more rational decisions. By being aware of the tendency to avoid losses, investors can work towards balancing their emotional responses with logical investment principles, potentially enhancing long-term performance.