Sunday, 1 July 2012

Loss Aversion

It's no secret, for example, that many investors will focus obsessively
on one investment that's losing money, even if the rest of their
portfolio is in the black. This behavior is called loss aversion.

Investors have been shown to be more likely to sell winning stocks in
an effort to "take some profits," while at the same time not wanting
to accept defeat in the case of the losers. Philip Fisher wrote in his
excellent book Common Stocks and Uncommon Profits that, "More
money has probably been lost by investors holding a stock they really
did not want until they could 'at least come out even' than from any
other single reason."

Regret also comes into play with loss aversion. It may lead us to be
unable to distinguish between a bad decision and a bad outcome.
We regret a bad outcome, such as a stretch of weak performance
from a given stock, even if we chose the investment for all the right
reasons. In this case, regret can lead us to make a bad sell decision,
such as selling a solid company at a bottom instead of buying more.
It also doesn't help that we tend to feel the pain of a loss more
strongly than we do the pleasure of a gain. It's this unwillingness to
accept the pain early that might cause us to "ride losers too long" in
the vain hope that they'll turn around and won't make us face the
consequences of our decisions.

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