What is Loss Aversion?
Loss aversion is a tendency in behavioral finance where investors are fearful of losses and try to avoid them more so than they tend to focus on making gains. For example, it is better to not lose $1,000 than it is to gain $1,000. The more one experiences losses, the more likely they are going to be prone to loss aversion. What’s interesting about loss aversion is that investors feel the pain of a loss between 2 and 2.5 times as much as they enjoy equivalent gains.
Selling Winners and Holding Losers
Many investors also believe a loss isn’t really a loss until it is realized. So that together with loss aversion, we actually find in practice that investors often will want to hold on to their losing stocks and sell their winning stocks when, in fact, they should be doing the reverse – selling their losers and riding their winners.
In fact, when investors studies are done, it has been found that individual investors were often twice as likely to sell winning stocks than their losing stocks. Well, how do you guard against a bias like this? This loss aversion bias? Certainly, stopping losses, which act as a form of pre-commitment, will help mitigate some of the investors holding on to those losing stocks and selling off their winners.
Examples of Loss Aversion
Below is a list of loss aversion examples that investors often fall into:
- Investing in low-return guaranteed investments over more attractive higher-risk higher-return investments
- Not selling a stock that has traded below the price it was purchased at (when rational analysis would suggest it should be sold)
- Selling a stock that has gone up in price to realize a gain (when rational analysis suggests it best to keep owning it)
- Telling oneself that it’s not a loss until it’s realized (the investment is sold)
Loss Aversion Strategies
Let’s look at some examples of how a company or an individual can avoid losses:
- Hedge against an investment by purchasing something that’s inversely correlated to the underlying investment
- Invest in insurance products that have a guaranteed rate of return
- Invest in government bonds
- Purchase investments with low price volatility
- Invest in companies that have an extremely strong balance sheet and cash flow generation
Thank you for reading this guide, we hope it provided a helpful overview of what an aversion to losses is, and what it means for investors. CFI provides the FMVA Financial Modeling designation, designed to help anyone be a world-class financial analyst.
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