What is Loss Aversion?
Loss aversion is a tendency in behavioral finance where investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains. The more one experiences losses, the more likely they are to become prone to loss aversion.
Research on loss aversion shows that investors feel the pain of a loss more than twice as strongly as they feel the enjoyment of making a profit.
Selling Winners and Holding Losers
Many investors don’t acknowledge a loss as being such until it is realized. Therefore, to avoid experiencing the pain of a “real” loss, they will continue to hold onto an investment even as their losses from it increase. This is because they can avoid psychologically or emotionally facing the fact of their loss as long as they haven’t yet closed out the trade. In their subconscious, if not their conscious, thinking, the loss doesn’t “count” until the investment is closed. The negative effect of this, of course, is that investors often continue to hold onto losing investments much longer than they should and end up suffering much bigger losses than necessary. That’s what loss aversion looks like in practice.
Well, how do you guard against the loss aversion bias? One practical step is to always use firm stop-loss orders to minimize your potential loss in any trade. That kind of pre-commitment to always limiting your risk helps to mitigate the tendency to fall into a loss aversion trap.
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 promising investments that carry higher risk
- Not selling a stock that you hold when your current rational analysis of the stock clearly indicates that it should be abandoned as an investment
- Selling a stock that has gone up slightly in price just to realize a gain of any amount, when your analysis indicates that the stock should be held longer for a much larger profit
- Telling oneself that an investment is not a loss until it’s realized (i.e., when the investment is sold)
Rational Strategies for Avoiding Losses
Let’s look at some examples of how a company or an individual can reasonably minimize risk exposure and losses:
- Hedge an existing investment by making a second investment that’s inversely correlated to the first investment
- Invest in insurance products that have a guaranteed rate of return
- Invest in government bonds
- Purchase investments with relatively low price volatility
- Consciously remain aware of loss aversion as a potential weakness in your investing decisions
- Invest in companies that have an extremely strong balance sheet and cash flow generation. (In other words, perform due diligence and only make investments that rational analysis indicates have genuine potential to significantly increase in value.)
Thank you for reading this CFI overview of what 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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