In continuation of the behavioral economics topics I’ve covered in the last few months, loss aversion is another topic that is important to understand when working with clients and reviewing positions in portfolios. Loss aversion is when a loss is perceived by individuals as more painful than a proportionate win.[1] For example, a loss of $100 is seen as worse than a gain of the same amount is seen as good. Most of us experience loss aversion. While it feels intuitive, loss aversion often leads to decisions that deviate from rational financial decision-making. A 50% gain in a portfolio is great, however a 50% loss can be devastating. We know that with a 50% loss, it would take a 100% gain from there just to get back to where you were. While the numerical analysis of loss aversion may not come naturally, the emotional impact of losses often feels stronger than gains.
Loss aversion leads to more than just bad feelings, it can cause us to make irrational decisions, especially in the finance realm. When you hear the term loss aversion, it is easy to believe that it would make an investor more conservative, and it does in some ways. However, it can also lead an investor to behave more aggressively, doubling down on positions where abandonment would be more beneficial, succumbing to the sunk-cost fallacy, and increasing risk-taking behavior.
We’ll look at two examples, one where an investor gained money, and one where an investor lost.
Investor A (Luna): Luna bought a stock that went up 30% in the last year. Sitting on a robust gain, Luna is worried about a market downturn that would erase all gains. An objective view of the company now shows massive upside potential in the multiple, a strong industry, rapidly growing earnings compared to peers, great analyst ratings, and massive enthusiasm. Although corrections happen and the news cycle is what it is, there is little reason to believe this company is in imminent danger. That said Luna, afraid of losing the gains that he already has, sells and stays in cash to ensure that he locks in his gain. Luna’s loss aversion eliminates the potential of gains going forward and leaves Luna to try to time his next investment.
Investor B (Sol): Sol bought a stock that decreased in value by 25%. It is a retailer where Sol purchases many goods, and he is noticing a store that often looks empty. However, he’s aware that a sample size of one is not statistically significant. Looking at the financials, the company has an unsustainable debt load, two executives resigned in the past month, earnings are not keeping pace with peers, online retailers are taking business away rapidly, the company has refused to invest in their online strategy, and analysts are panicking about the stock. Sol, however, knows that markets are cyclical and believes the retailer will recover, although markets have been rising during this decrease in the market cap for the retailer. When asked if Sol would purchase this company at current prices, he says he wouldn’t. Nevertheless, Sol holds the stock despite acknowledging it is in a losing position with few prospects for a near-term turnaround.
These examples illustrate how loss aversion can affect investors in multiple ways. People often want to lock in gains while making sure not to lock in losses. Holding on to an investment that you still feel great about is rational. However, holding on to an investment simply because you’re reluctant to lock in losses is gambling behavior. To mitigate loss aversion, it is important to stick to a strategic asset allocation approach and rebalance periodically to take emotion out of it. Objectivity is key, but we are emotional creatures, so it is difficult to combat behavioral biases without a disciplined approach.
Key Takeaways:
[1] Liberto, D. (2024, April 26). Loss Aversion: Definition, Risks in Trading, and How to Minimize. Investopedia. https://www.investopedia.com/terms/l/loss-psychology.asp
