Loss Aversion: Definition, Risks in Trading, and How to Minimize

What Is Loss Aversion?

Loss aversion in behavioral economics refers to a phenomenon where a real or potential loss is perceived by individuals as psychologically or emotionally more severe than an equivalent gain. For instance, the pain of losing $100 is often far greater than the joy gained in finding the same amount.

The psychological effects of experiencing a loss or even facing the possibility of a loss might even induce risk-taking behavior that could make realized losses even more likely or more severe.

Key Takeaways

  • Loss aversion is the observation that human beings experience losses asymmetrically more severely than equivalent gains.
  • This overwhelming fear of loss can cause investors to behave irrationally and make bad decisions, such as holding onto a stock for too long or too little time.
  • Investors can avoid psychological traps by adopting a strategic asset allocation strategy, thinking rationally, and not letting emotion get the better of them.

Understanding Loss Aversion

Nobody likes to lose, especially when it could result in losing money. The fear of realizing a loss can cripple an investor, prompting them to hold onto a losing investment long after it should have been sold or to offload winning stocks too soon—a cognitive 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.

Behavioral economists claim that humans are wired for loss aversion, one of many cognitive biases identified by. Some psychological studies suggest that the pain of losing is psychologically about twice as powerful as the joy we experience when winning. However, several studies also call into question the practical effect or even the existence of loss aversion. Nonetheless, it may be possible that overwhelming fear can cause investors to behave irrationally and make poor investment decisions.

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 ones. According to prospect theory, people strongly prefer avoiding losses than they do acquiring gains.

This loss aversion is so strong that it can lead to negativity bias. In such cases, 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.

Minimizing Loss Aversion

One way of avoiding psychological traps is to follow a strategic asset allocation strategy. Rather than trying to perfectly time market sentiment, and abide by the old adage of letting your winners run, investors are advised to rebalance portfolios periodically, according to a rules-based methodology.

Formula investing is another form of strategic investment. 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 employing 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.

Some Upside to Loss Psychology

Behavioral finance provides scientific insights into our cognitive reasoning and investment decisions; at a collective level, it helps us understand why bubbles and market panics might 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.

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 making emotionally-based, panic-driven decisions. Smart investors focus on rational and prudent trading strategies, preventing them from falling into the common traps that arise when psychology and emotions affect judgments.

Why Do Losses Loom Larger Than Gains?

There are several possible explanations for loss aversion. Psychologists point to how our brains are wired and that over the course of our evolutionary history, protecting against losses has been more advantageous for survival than seeking gains. Sociologists point to the fact that we are socially conditioned to fear losing, in everything from monetary losses but also in competitive activities like sports and games to being rejected by a date.

How Can Loss Aversion Explain Increased Risk-Taking Behavior?

Rather than deal with the psychological pain of actually locking in a loss and realizing it, those with paper losses may be inclined to take on even greater risk in hopes of breaking even—for instance, doubling-down at the casino when experiencing a bout of bad luck.

Is Everybody Risk Averse?

Human beings tend to be loss averse; however, different people display different levels of loss aversion. Research has shown, for example, that people trained as economists or who are professional traders tend to exhibit, on average, lower levels of loss aversion than others.

How Is Loss Aversion Different From Risk Aversion?

Everybody has a unique risk tolerance. This is based on personal circumstances like assets and income, as well as investment time horizon (e.g. time until retirement), age, and other demographic characteristics. People who are more risk-averse will take on less risk than those who are risk-seeking. Risk aversion, however, is completely rational since both losses and gains at any level of risk-taking would be viewed symmetrically. It is the asymmetry of loss aversion where losses loom larger than gains—at any level of risk tolerance—that is irrational and problematic.

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  1. Jordan, Douglas, and J. David Diltz. "Day Traders and the Disposition Effect." The Journal of Behavioral Finance, vol. 5, no. 4, 2004, pp. 192-200.

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