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.”