Investor's Psychology

Loss Aversion Bias: When fear fuels loss!

Created on 23 Aug 2022

Wraps up in 6 Min

Read by 557 people

Updated on 11 Sep 2022

Does it make you curious why people invest in an FD at a low-interest rate, not stocks? Why does an investor sell their stocks during the stock market downturn, although there is a chance for them to rebound later? These types of behaviours indicate signs of loss aversion bias. Loss aversion bias reflects a strong tendency to avoid losses over acquiring gains from an outcome. 

To put it simply, one of the dialogues from Hera Pheri explains it aptly. It is perfectly interpreted when Baburao says, "Bilkul ricks nahi lene ka!" You can find such Baburaos who would not be able to distinguish between a bad decision and a poor outcome while faced with a loss. All because the emotional pang of facing a loss is a lot more severe than the thrill of an equal profit.

The same tendency multiplies itself and attracts more irrational decisions while investing. So let's learn how to avoid being a Baburao and avoid loss aversion bias. 

What is Loss Aversion Bias?

Coreen T Sol rightly said, "Generally, you'll be motivated to sell sound investments and hold onto the bad ones because you would prefer to feel good about the gains and avoid the pain of acknowledging loss."

Loss aversion's meaning spells out that an individual discerns real loss as emotionally and psychologically more severe than an equivalent gain. Loss aversion bias impacts the economic decision-making process of institutions and individuals. 

A loss aversion example is that it can push investors to sell their stocks when the market is facing a downturn despite the chances of an uptrend. They do that to avoid any other further losses. It means they would miss out on the gains when the price of the same stocks rebounds.

Impact of Loss Aversion Bias

As a psychological bias, loss aversion affects investors in various ways. The common end result of this bias is reduced return on portfolios caused by the following effects.

  • Investors tend to become overly prudent, which drives them to prioritise a loss-avoiding decision over earning gains. As a result, investors employ their capital in "safer" instruments, reducing their returns. At the same time, they will completely avoid possible gains due to the threat of the smallest amount of risk.

  • If investors do engage in shares by looking beyond their inherent "risk", loss aversion bias can lead to conservative portfolios. As a result, investors end up including shares with weaker prospects in their portfolio, foregoing losses.

  • Due to forced and excessive prudence, investors might not experience significant losses, but their profits will be underwhelming and not up to par with the market. Thus, the inflation-beating property of investment goes to waste.

  • It can further drive them to make irrational investment decisions like panic selling or holding poor securities.

Decoding the Concept of Loss Aversion Bias

Peter H Diamandis said, "In trying to make sense of this pessimism, Ridley, like Kahneman, sees a combination of cognitive biases and evolutionary psychology as the core of the problem. He fingers loss aversion—a tendency for people to regret a loss more than a similar gain—as the bias with the most impact on abundance. Loss aversion is often what keeps people stuck in ruts."

Loss aversion is common in decision theory, cognitive psychology, and behavioural economics. It can impact the everyday decisions of people related to finance and investment. As individuals, it is natural that we fear experiencing losses. 

This fear of loss is necessary but can also prevent you from making a well-calculated risk that holds the potential for worthwhile returns. It can further prevent an individual from implementing innovative yet partially riskier solutions.

Many psychologists describe this phenomenon to cause the pain of losing twice as powerful as the joy of winning. Some possible explanations are mentioned below for why losses loom larger than gains.

  • Three specific regions of the brain get activated during situations that involve losses. Along with many other aspects of brain, the strength of these three regions conveys an individual's likeliness to be averse. 

  • The social hierarchy of an individual indicates their level of loss aversion. 

  • Another explanation is about the variations in culture. For instance, an individual from a collectivist culture is more likely to take risks than an individualist counterpart.

The amygdala, striatum, and insula regions of our brain are responsible for processing our reaction to a loss.

How to Reduce Loss Aversion Bias?

"Once bitten, twice shy isn't a very good investment strategy." - Coreen T Sol.

The phenomenon of loss aversion is so strong that investors can focus more on bad news than on good ones. It can further reduce their focus on the bull market. So, it is advised to minimise the loss aversion bias. Some of the proven ways to mitigate the loss aversion bias are:

1. Strategic Allocation Strategy

This strategy suggests that one can set specific targets and then rebalance their portfolio in shorter periods. The technique is akin to a buy-and-hold strategy. It promotes the idea of diversification for cutting back on risks and improving returns. 

2. Formula Investment

This strategy is related to how an investor invests in securities or funds, handles asset allocation or decides how and when money has to be invested. 

3. Other Ways

Some other tried and tested principles that work best for minimising loss aversion include buy-and-hold strategies, building diversified portfolios, etc. 

 According to a study conducted by Dr Mei Wang, people from Eastern European countries are more loss averse than those from African countries. 

What are the Disadvantages of Loss Aversion?

Some of the disadvantages of loss aversion bias are: 

1. Investment in risk-free products

Investment in safe products with little to no returns is one of the cons. This reduces their purchasing power because of inflation. Several people tend to reject an investment deal below their baseline. The reason behind it is not that the deal was bad, but because they could not bear the concession.

2. More focus on lost investments

Often, the investors focus more on the lost investment. They experience the loss severely and forget about their other sound investments. Loss aversion bias often makes them sell off their sound investments prematurely to prevent themselves from experiencing loss. 

3. Having the belief that you have not lost until you have sold

In such scenarios, one can see that few investors hold on to their stocks for a longer period than selling them at a loss, especially when it is predicted the price will not rise. This prevents them from making better investments in alternative options. It worsens when the investor finally decides to sell that stock, as the return on investment would be lower afterwards. 

4. Making irrational decisions

Showing an inability to distinguish between a bad decision and a poor outcome while feeling the regret of experiencing a loss can lead to missing out on gainful opportunities. 

5. Loss aversion bias in real estate

The bias is commonly observed in real estate investments when investors refuse to sell their properties at a loss. They hold on to them for a long time, hoping they will become profitable. Many of them even pay the interest on loans during the holding period, which otherwise can be avoided. 

Conclusion

Loss aversion is indeed something to ponder about. Who would have thought that economics, finance, and psychology had such a significant relationship? On an end note, loss aversion is simply an innate tendency to prefer avoiding losses over gaining similar achievements. 

However, it can impact your investment decisions considerably. So, do remember some of these fundamentals of loss aversion.

Have you ever faced loss aversion bias? Let us know in the comments section.

An Article By -

Deb P Samaddar

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Deb is a keen learner and eager to learn about the finance world. He is that person who would never stop talking, but my oh my, the words he uses, are not something a normal human would in a regular conversation. While the conversations are well, interesting, the write-ups are faultless. With an increased proclivity towards tech and language, he aims to capitalise on his interests as a content writer at Finology.

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