Thursday, 12 January 2017

Asymmetric Loss Aversion

The pain of a loss is far greater than the enjoyment of a gain.

Many experiments have demonstrated that people need twice as much positive to overcome a negative.

On a 50/50 bet, with precisely even odds, most people will not risk anything unless the potential gain is twice as high as the potential loss.

This is known as asymmetric loss aversion:  the downside has a greater impact than the upside.

This is a fundamental bit of human psychology.

Applied to the stock market

It means that investors feel twice as bad about losing money as they feel good about picking a winner.

This line of reasoning can be found in macroeconomic theory, which points out that:

  • during boom times, consumers typically increase their purchases by an extra three-and-half cents for every dollar of wealth creation, and
  • during economic slides, consumers will actually reduce their spending by almost twice that amount (six cents) for every dollar lost in the market.

The impact of loss aversion on investment decisions

This is obvious and profound.

1.    Not selling our losers

We all want to believe we made good decisions.   

To preserve our good opinion of ourselves, we hold onto bad choices far too long, in the vague hope that things will turn around.

By not selling our losers, we never have to confront our failures.

2.   Unduly conservative

This aversion to loss makes investors unduly conservative.

Participants in 401(k) plans, whose time horizon is decades, still keep as much as 30 to 40 percent of their money invested in the bond market.

Why?  Only a deep felt aversion to loss would make anyone allocate funds so conservatively.

3.  Irrationally holding onto losing stocks, potentially giving up a gain from reinvesting

But loss aversion can affect you in a more immediate way, by making you irrationally hold onto losing stocks.

No one wants to admit making a mistake.

But if you don't sell a mistake, you are potentially giving up a gain that you could earn by reinvesting smartly.

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