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Tuesday, 1 July 2014

L is for Loss Aversion

Loss Aversion is the name given to our aversion to losses (duh). We're twice as unhappy at a loss as we're happy at an equivalent gain, which leads us into keeping rubbish investments (to avoid realizing a loss) and into selling good ones (because then we can never take a loss). Under loss aversion selling or buying has no relationship to the actual investment merits of the asset, it's all about our emotional attachment to an arbitrary number.

Example

Loss aversion has been demonstrated many, many times in investing but it applies in plenty of other areas of life as well. In one clever study the researchers looked at professional golfers when they're putting for a par (to avoid a loss) or for a birdie (to achieve a profit). Adjusting for the various positions of the ball, wind direction and the occasional interloper it turns out that even professional golfers are more likely to stick the ball in the hole when they're trying to avoid a loss than when trying to achieve a profit.

Loss aversion is very powerful.

Causes

Loss aversion seems to be linked to one single, but very human, emotion: we don't like losing (duh, duh). The pleasure-pain principle has a long history in psychology, and it proposes (rather sensibly) that, given a free choice, we seek out pleasure and try to avoid pain. So avoiding losses, which some studies suggest may well cause us physical as well as psychic pain, is a sensible emotional reaction. It's just not a very useful investing behavior.

Mitigation

A loss (or a profit) is an issue of anchoring and framing, so if you can lose the information that creates the anchor (your buying price) and the frame (you're facing taking a loss) then you can avoid the problem. Assuming you can't then try this ...

Any stock you currently hold you should be willing to buy more of. If you're not willing to buy more of it then why are you holding it? The answer, of course, is loss aversion. So, every quarter buy more stock in your three worst performers. If you can't bring yourself to do it you're suffering from loss aversion. Sell 'em and move on.

2 comments:

  1. I've always had trouble with this one. If one diligently held winners and sold losers, wouldn't that just be momentum investing? If the investment case is still intact, a stock that goes down needn't be a rubbish investment. To know so would be to know the future. At best all stock purchases are just educated guesses about what the future holds and more to the point, what the future holds relative to what future is already priced into the stock.

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  2. The point is, under loss aversion, that investors sell profitable stocks because they're profitable and keep loss making stocks because they're loss making. Nothing here says you shouldn't sell a profitable stock or keep a loss making one - it's all about the reasoning behind it.

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