What Is Loss Psychology?

Loss psychology refers to the emotional side of investing, namely the negative sentiment associated with recognizing a loss and its psychological effects.

Humans are wired for loss aversion, one of many cognitive biases identified by behavioral economists. Research shows that the pain of losing is psychologically about twice as powerful as the joy we experience when winning. This overwhelming fear can cause investors to behave irrationally and make poor investment decisions.

Key Takeaways

  • Loss psychology refers to the emotional side of investing, namely the negative sentiment associated with recognizing a loss and its psychological effects.
  • This overwhelming fear 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 Psychology

Nobody likes to lose, especially when it could result in losing money. The fear of realizing a loss can cripple an investor, prompting him or her to hold onto a losing investment long after it should have been sold or offload 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 ones. 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. 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.

Loss Psychology Methods

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.

Advantages of 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 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.