DEFINITION of 'Loss Psychology'

Loss psychology is about the emotional side of investing and the negative sentiment associated with recognizing a loss and its psychological effects. Humans are wired for loss aversion, one of many cognitive biases that behavioral economists have identified, and which can cause investors to behave irrationally and make bad investment decisions. One way of avoiding these pitfalls is to pursue more strategic asset allocation strategies.

BREAKING DOWN 'Loss Psychology'

The fear of realizing a loss can cripple an investor who holds onto a losing investment long after it should have been sold, or sells winning stocks too soon — a bias known as the disposition effect. Rookies often make the mistake of hoping a stock will bounce back, against all evidence to the contrary, because losses lead to more extreme emotional responses than gains.

Loss psychology may even be the cause of the asymmetric volatility phenomenon exhibited in stock markets, where equity market volatility is higher in declining markets than in rising markets. According to prospect theory, people strongly prefer avoiding losses than acquiring gains. This loss aversion is so strong that it can lead to negativity bias where investors put more weight on bad news than on good news, causing them to miss out on bull markets — for fear that they will reverse course — and panic when markets sell off.

Behavioral finance is helping to provide scientific insights into our cognitive reasoning and investment decisions — and at a collective level, helps us understand why bubbles and market panics occur. Investors need to understand behavioral finance, not only to be able to capitalize on stock and bond market fluctuations, but also to be more aware of their own decision-making process.

Dealing With Loss Psychology Through Strategic Asset Allocation

One way of avoiding psychological traps is to follow a strategic asset allocation strategy, and rebalance the portfolio periodically, according to a rules-based methodology, rather than trying to perfectly time market sentiment – though this runs counter to the old adage of letting your winners run.

Formula investing is another form of strategic investment strategy. For example, constant ratio plans keep the aggressive and conservative portions of a portfolio set at a fixed ratio. To maintain the target weights — typically of stocks and bonds — the portfolio is periodically rebalanced by selling outperforming assets and buying underperforming ones. This runs counter to momentum investing, which is pro-cyclical.

There are many tried and tested principles for asset allocation and fund management, such as learning to build diversified portfolios and using buy and hold strategies. Another systematic way of investing is using Smart beta strategies, such as equal weight portfolios, to avoid market inefficiencies that creep into index investing - due to the reliance on market capitalization. Factor investing can also be used to mitigate such market risk factors.

Learning From Investment Losses

Losses can have a value if you learn from them, and look at things dispassionately and strategically Losses are inevitable, which is why successful investors incorporate “loss psychology” into their investment strategies, and use coping strategies.

To break free from their fear of financial losses and overcome cognitive biases, they learn to handle negative experiences and avoid emotionally-based, panicky decisions, by focusing on rational and prudent trading strategies. That way they learn how to avoid falling into the common traps that arise when psychology and emotions affect decision-making.

For further reading, see Trading Psychology And Discipline and Master Your Trading Mindtraps.)

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