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.

Rational thinking about Irrational pricing. For the most acutely loss-averse investors, pure value investing is most suitable.

1.  Depressed investors cause depressed stock market prices.

2.  Selling pressure mounts and drives prices down.

3.  Investors possessing even MODEST degrees of aversion to loss capitulate quickly, and the LESS FEARSOME succumb soon after.

4.  A downward market spiral ensures.

5.  Value investors avoid these scenarios by forming a clear assessment of their averseness to loss.

6.  Only having assessed this characteristic honestly do they brave the choppy waters of stock picking.

7.  One way to grasp one's own loss aversion is to recognize that most people experience the pain of loss as a multiple compared to the joy of gain.

8.  The average person greets losses with aversion on the order of about 2.5 times their reception of winnings.

9.  The greater one's loss aversion, the greater value investing's appeal.  

10.  For the most acutely loss-averse investors, pure value investing is most suitable.

11.  Benjamin Graham was extremely risk averse.

Stung by Losses, Main Street Investors Fail to Notice Market's Rebound

By Karen Weise on September 19, 2012

Although the memory of Lehman Brothers’ 2008 collapse may be fading on Wall Street, the shock still lingers on Main Street—and may again be hurting ordinary investors. A new survey of individual investors is a reminder of just how much we are primal creatures that remember the pain of loss more than the joy of gains.

As my colleague Roben Farzad recently reminded us, the Standard & Poor’s 500-stock index is on a tear, rallying on rising corporate profits (including Apple’s (AAPL)earnings bonanza) and optimism about further help from the Federal Reserve. Since its nadir in March 2009, the S&P 500 has more than doubled and is now at 1,463, not that far from the all-time high of 1,526 it reached in September 2007.

But ask Main Street investors, and you find that the market isn’t all roses: Memories of the steep losses from 2008 and 2009 still haunt, causing them to underestimate the market’s performance.

Franklin Templeton (BEN) surveys individual investors annually, asking how they perceive the market’s performance in the previous year. In 2010, 66 percent of investors said the S&P had fallen in 2009, when it actually had gained 26.5 percent—in a year following a steep 37 percent plunge. In 2011, 48 percent of investors said the markets were down over the course of 2010, when the S&P had risen more than 15 percent. And data just released on Sept. 18 shows that 53 percent of investors think the S&P declined in 2011, when the index actually rose 2 percent.

It’s fair to wonder if investors who don’t know whether the S&P made or lost money the prior year are sufficiently attuned to the market to risk cash in it. However, Franklin Templeton’s survey is also a marketing exercise—the company is a major mutual fund seller that would like to help guide you into investing.

The S&P has gained more than 16 percent so far this year, but that’s no reason to to think investors have suddenly overcome their post-crash trauma. They have continued pulling out of equities, taking more than $66 billion (XLS) out of the U.S. stock market in 2012.

This fear of getting burned again—“loss aversion,” in financial psychology lingo—means that Main Street is being hit by a double whammy. Not only did individual investors take a beating when the market tanked, they’re not benefiting from its rebound, either.

Weise is a reporter for Bloomberg Businessweek.

http://www.businessweek.com/articles/2012-09-19/stung-by-loss-main-street-investors-dont-see-markets-rebound

Loss Aversion: The Shortsightedness of “Playing Not to Lose”

We experience the pain of a loss much more acutely than we experience the pleasure of a gain. One result is that we overreact to price increases.

Asymmetrical reaction to price fluctuations

Imagine you’re at the supermarket, about to buy your favorite brand of peanut butter. If you see that the price has dropped, you’re mildly pleased. But if you see the price has increased by the same amount, you get that awful sinking feeling. Disappointed, you put it back on the shelf and go without.

But it’s not just the potential loss of money that we overreact to. It can be the loss of time, prestige… or a game of football.

The best explanation of loss aversion I’ve ever read appears the book, Sway: The Irresistible Pull of Irrational Behavior. Authors Ori and Rom Brafman give some great examples of how loss aversion can lead us to make the most irrational, self-defeating decisions. Below are two real-world examples from Sway:

1.  A pilot’s obsession with getting back on schedule

In the 1970’s, Captain Jacob van Zanten was KLM’s most esteemed pilot. He was their chief flight instructor and even appeared in KLM advertising.

On a flight to the Canary Islands in March of 1977, van Zanten’s 747 was diverted to a smaller, nearby airport. After several frustrating delays, van Zanten — driven by an obsession to get back on schedule — started to take off in thick fog without full takeoff clearance. What he didn’t know was that a fully loaded Pan Am 747 was sitting on the runway, directly in his path.

The KLM jumbo smashed into the Pam Am plane. Everyone on board the KLM flight was killed, as were most of those on the Pan Am flight. There were 584 fatalities – the worst air disaster ever. And it was caused mainly by the KLM pilot’s obsession with living up to KLM’s claim of being “the people who made punctuality possible”. In other words, avoiding a loss.

2.  Playing not to lose

When Steve Spurrier took over as coach for the University of Florida Gators in 1990, he spotted a weakness in his opponents’ strategy. The other teams in his conference all played very conservative, defensive games. In other words, they were playing not to lose.

Spurrier exploited his opponents’ obsession over avoiding losses. He had his team take some chances, pass more often, play more aggressively, and try to score. The strategy was a huge success and it illustrates the opportunities that exist when we recognize irrational behavior for what it is.

You’d think the opposing coaches, seeing what was happening, would have changed strategy and played more aggressively. But they simply couldn’t. They had become so committed to the goal of avoiding a loss that for years they continued their losing strategy.

http://www.cardinalpath.com/loss-aversion-the-shortsightedness-of-%E2%80%9Cplaying-not-to-lose%E2%80%9D/

Loss Aversion

"losses loom larger than corresponding gains"

"In prospect theory, loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Some studies suggest that losses are as much as twice as psychologically powerful as gains. Loss aversion was first convincingly demonstrated by Amos Tversky and Daniel Kahneman."

"The principle of loss aversion was first introduced by Kahneman and Tversky (1979)"

Tversky and Kahneman (1991) "The central assumption of the theory is that losses and disadvantages have greater impact on preferences than gains and advantages."

"Numerous studies have shown that people feel losses more deeply than gains of the same value (Kahneman and Tversky 1979, Tversky and Kahneman 1991)."
Goldberg and von Nitzsch (1999) pages 97-98

"Both the status quo bias and the endowment effect are part of a more general issue known as loss aversion." (Montier 2007, p. 32)

Loss aversion - Wikipedia

The Psychology Of Loss Aversion (And How It Applies To Venture Capital)

Rob Go|August 17, 2010

• 

I’ve been reading the book “The Black Swan” recently on the recommendation of my two partners.  I had heard about the book for years, but it never made it off my “to-read” list until now.

One of the concepts that the book discusses is the way we think of risk differently when we are generating profits vs. when we are minimizing losses.  The simple illustration goes something like this:

If someone gave you the offer of $100, no strings attached, vs. flipping a coin for the chance of winning $200, what would you choose?  Although both options are mathematically equivalent, most folks would choose the $100.

On the flip side, if things were reversed, and you could either lose $100 for sure, or have a 50% chance of losing $200 or nothing, what would you choose?  Most people in this situation tend to prefer the possibility of losing nothing, even though there is the 50% chance of a larger loss.  

This illustrates a simple point that we tend to be irrationally risk tolerant in protecting capital.  Social scientists call this loss aversion.

This has major implications for the venture business in the realm of follow-on investment decisions.  It’s a part of the business that doesn’t get much attention, but consider this:  I think it’s safe to say that well over 50% of a typical venture firm’s capital actually comes in after the initial investment round of financing for a company.  So even if a fund is supposed to be “early stage” focused, the reality is that the bulk of their capital is going into the follow-on investments in the B, C, D and later rounds. 

I didn’t realize this before I went into VC, but most VC firms are lifecycle investors, meaning that they have large reserves and expect to participate in most of the follow on rounds for companies that are doing reasonably well.  One would think that the follow-on investing decision for VC’s would be an easy one.  After all, no one has more information on a company than the existing investors and board directors.  Therefore, they should be very well equipped in figuring out which companies deserve follow-on capital, and which ones don’t.  Even though the follow-on capital is usually at a higher cost base than the earlier investments, this should be concentrated in the “best” companies, and should perform very well from a risk adjusted basis (even before considering the protection from being higher up in the preference stack).

Case closed right? Wrong.  There are a lot of reasons why follow-on financings might happen when they shouldn’t, causing VC’s  to “pour in good money after bad”.   

• Loss Aversion.  As discussed above, the uber-reason this happens is that one is irrationally risk tolerant when trying to preserve capital.  Or put another way, once you have a vested interest (time or money) into a company, you are willing to take irrational risks to protect your investment.   

• Delayed Gratification.  No investor wants to see a “zero” on their track record, and no investor wants to report “zeros” to LP’s.  This is true even though a small -100% return today might be much much better than a big -80% return in 5 years.  The pressure of needing to raise a future fund, looking good in front of your partners, trying to get promoted, trying to look like a clever guy in the twitterverse, etc leads to unnecessary risk-taking in follow-on financing decisions.  Even though almost every firm says they evaluate follow-on rounds like “new deals”,  I think this is actually far from reality.

• The Signaling Death Spiral.  Let’s take the hypothetical case of a company raising a series B that is doing ok, but not great.  The existing investors will often say they will support the company but have an outside lead price the round.  The new investor will ask the existing investors if they are “in” for their pro rata as a signal that it’s worth investing.  If an outside lead is willing to price and lead a round, it’s very very hard for the existing investor to say “you know what, I don’t believe in this.  I’m going to pass on this investment and risk that the whole deal blows up” (note that this is different than the follow-on dynamics of VC led seeds, where the investor will have a much smaller % of capital at risk and knows that they are buying 5 options to make 1 true investment.)  So in this scenario, a follow-on round gets done, and both parties are heavily influenced by the fact that the other is investing.  Puzzling no?

• Confirmation Bias.  This is the tendency for people to favor information that confirms their preconceptions regardless of whether that information is true or complete.  When layered in with Loss Aversion, it creates a deadly combination.  Because an investor is averse to losses, he/she is biased against any data that suggests that the initial investment decision was a mistake and will gravitate towards information that supports a follow-on investment.  

• The Bridge to Nowhere.  Even if a company is really struggling, the following logic is very appealing: wouldn’t you be willing to spend $2M to save the last $8M?  Because investors usually buy preferred stock, they get paid first and so they only need the company to sell for the value of the preferred stock to get their money back.  As a result, you often see struggling companies raise inside rounds under this logic (often crushing the employee’s equity in the process).  But many times, this round of “bridge” financing ends up being a bridge to nowhere.

So, follow-on investing ends up being a much more complicated endeavor than it would first appear.  Clearly, there are some firms out there that have a great deal of discipline about follow-on financing and have been very successful.  But I think that this is a very very easy way to falter as an investor because it’s so natural to fall prey to these pitfalls.  As some super-angel funds increase in size, it will be interesting to see how they deal with these hurdles as well.  It’s easy to say that one will “pile in on their winners”, but the ability to do so will cut both ways.

Read more: http://articles.businessinsider.com/2010-08-17/strategy/30074026_1_venture-capital-investors-loss-aversion#ixzz1vzJKzpZV

Risk avoidance is the single most important element of an investment program

Another common belief is that risk avoidance is incompatible with investment success. This view holds that high return is attainable only by incurring high risk and that long-term investment success is attainable only by seeking out and bearing, rather than avoiding, risk. Why do I believe, conversely, that risk avoidance is the single most important element of an investment program? 

If you had $1,000, would you be willing to wager it, double or nothing, on a fair coin toss? Probably not.  Would you risk your entire net worth on such a gamble? Of course not. Would you risk the loss of, say, 30 percent of your net worth for an equivalent gain? Not many people would because the loss of a substantial amount of money could impair their standard of living while a comparable gain might not improve it commensurately. If you are one of the vast majority of investors who are risk averse, then loss avoidance must be the cornerstone of your investment philosophy.

Greedy, short-term-oriented investors may lose sight of a sound mathematical reason for avoiding loss: the effects of compounding even moderate returns over many years are compelling, if not downright mind boggling.

Perseverance at even relatively modest rates of return is of the utmost importance in compounding
your net worth. A corollary to the importance of compounding is that it is very difficult to recover from even one large loss, which could literally destroy all at once the beneficial effects of many years of investment success. In other words, an investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains but with considerable risk of principal An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent the tenth year.

The Law of Investing

This is one of the most important of all the laws of money.

The Law of Investing – investigate before you invest. This is one of the most important of all the laws of money. You should spend at least as much time studying a particular investment as you do earning the money to put into that particular investment.

Check Every Detail
Never let yourself be rushed into parting with money. You have worked too hard to earn it and taken too long to accumulate it. Investigate every aspect of the investment well before you make any commitment. Ask for full and complete disclosure of every detail. Demand honest, accurate and adequate information on any investment of any kind. If you have any doubt or misgivings at all, you will probably be better off keeping your money in the bank or in a money market investment account than you would be speculating or taking the risk of losing it.

Money is Easy to Lose
The first corollary of the Law of Investing is: "The only thing easy about money is losing it." It is hard to make money in a competitive market but losing it is one of the easiest things you can ever do. A Japanese proverb says, "Making money is like digging with a nail, while losing money is like pouring water on the sand."

The Best Rule of All
The second corollary of this law comes from the self-made billionaire, Marvin Davis, who was asked about his rules for making money in an interview in Forbes Magazine.

He said that he has one simple rule and it is, "Don’t lose money." He said that if there is a possibility that you will lose your money, don’t part with it in the first place. This principal is so important that you should write it down and put it where you can see it. Read it and reread it over and over.

Time Equals Money
Think of your money as if it were a piece of your life. You have to exchange a certain number of hours, weeks and even years of your time in order to generate a certain amount of money for savings or investment. That time is irreplaceable. It is a part of your precious life that is gone forever. If all you do is hold on to the money, rather than losing it, that alone can assure that you achieve financial security. Don’t lose money.

Be Smart About Investing
The third corollary of the Law of Investing says: "If you think you can afford to lose a little, you’re going to end up losing a lot."

There is something about the attitude of a person who feels that he has enough money that he can afford to risk losing a little. You remember the old saying, "A fool and his money are soon parted." There’s another saying, "When a man with experience meets a man with money, the man with the money is going to end up with the experience and the man with the experience is going to end up with the money." Always ask yourself what would happen if you lost one hundred percent of your money in a prospective investment. Could you handle that? If you could not, don’t make the investment in the first place.

Action Exercises
Here are two things you can do to apply this law immediately:

First, think back over the various financial mistakes you have made in your life. What did they have in common? What can you learn from them? Accurate diagnosis is half the cure.

Second, invest only in things that you fully understand and believe in. Take investment advice only from people who are financially successful from taking their own advice. Play it safe. It’s better to hold onto your money rather than to take a chance of losing it, along with all the time it took you to earn it.

Posted by Brian Tracy on Nov 21, 2008

http://www.briantracy.com/blog/financial-success/the-law-of-investing/

Loss Aversion versus Risk Aversion

http://www.ppfas.com/media/articles/how-the-wish.pdf


"It makes sense to ride the winners and sell the losers, but loss aversion makes people do the exact opposite."

Why do most portfolios have a few winners but a long list of losers? Why are your profits from your winners smaller than your losses from your losers? Due to loss aversion, investors sell their winners fast and hold on to the losers. Investors behave as if the loss occurs when the sale is made, when in fact the loss has already occurred, with the depreciation in price. Offsetting a loss against other income has tax benefits, too - it makes good sense to ride the winners and sell the losers. But loss aversion makes people do the exact opposite.

Why investors behave the way they do

Why investors behave the way they do
Published: 2009/04/01

Learning from other market players’ mistakes; analysing how and what they think, can help an investor emerge as a winner in the market

In recent years, behavioural finance has been gaining grounds in trying to explain the financial anomalies in the stock market. These anomalies, which cannot be addressed by traditional financial theory such as the market efficiency theory may sound purely theoretical, but you cannot brush aside the need to understand the psychology of investors as it plays a big part in driving the stock market.

What is Behavioural Finance?


Behavioural finance is the study to explain the financial behaviour from the psychological aspect. Over the years, market psychologists have discovered that the two primary emotions that drive investors' risk-taking behaviour are hope and fear. There are a few key behavioural concepts that will help us to understand why some of us behave in certain ways when it comes to making investment decisions. In this article, we talk about four of such concepts:

* Regret theory


Regret, a simple enough concept to understand by any layman, refers to the emotional experience that one goes through when confronted with the wrong decision that he or she has made. It manifests itself in the form of pain when one feels responsible for not doing the right thing. When you look back at your investment history, try to recall the state you were in when you missed the chance to cut losses or missed the opportunity to buy a stock that you knew you should have bought because it was considered a good buy. Try and remember how you felt when the price of that particular stock that you did not buy increased subsequently. This emotion often becomes embedded in someone's mind in such a way that it regulates his or her future actions and decisions.

As a result, most investors make it a habit to avoid selling a loss-making stock and instead hope that the price will rebound eventually - all this, to avoid the feeling of regret. They would much rather make a paper loss than admit that they have made a mistake. In some cases, where the bad decisions happen to be recommended by their financial advisers, investors will put the blame on the advisers to avoid regret.

* Prospect theory

Prospect theory developed by Daniel Kahneman and Amos Tversky (1979), states that "we have an irrational tendency to be less willing to gamble with profits than with losses". Kahneman and Tversky found that when confronted with the choice between accepting a sure loss and taking a chance, most people will choose the latter. This phenomenon is called "loss aversion", which basically means that in general, people hate to lose. So, when faced with a situation involving loss, they become risk takers; they take the chance even if there is only the slightest hope of not having to lose.

On the other hand, when presented with a sure gain, they usually become risk-averse. Investors who behave this way tend to mark their stocks to the price that they originally paid to secure them and not to market. As such, they aim to get even before closing out a position. This type of investors usually ends up holding on to their loss-making stocks for far too long, which may very well prove detrimental to them in the end.


* Overconfidence

It is human nature for us to over-estimate our abilities and shower ourselves with a little too much confidence, i.e, overconfidence. Studies show that investors are often overconfident when it comes to their ability to predict the market's direction. Oddly enough, this is something that is more prominent among novice investors. Compared to experienced investors, those who are new to the market tend to set higher return expectations and end up being overwhelmed by the unfavourable outcome. As a result of overconfidence, some investors tend to trade too frequently only to get unsatisfactory returns or worse yet, losses. With the convenience of online trading, some even quit their full-time jobs to do day trading, thinking that they have the ability to predict the market and earn fast money. These are the people that usually end up getting burned if they do so without proper understanding of what they have been buying and selling, especially when the market is highly volatile.


* Anchoring


This is a behavioural phenomenon in which people tend to extrapolate the past into the future, putting heavier weight on the recent past. At times, when there are new announcements from companies, analysts fail to adjust their earnings forecast for the companies to reflect the latest information due to the anchoring effect. As a result, they land themselves with a few surprises when positive news become more positive and vice versa.

What has been discussed above are a few common behavioural phenomena experienced by investors that are useful to know. By understanding the psychology behind investors' behaviours, you can learn to recognise mistakes and avoid making such mistakes yourself. Learning from other market players' mistakes; analysing how and what they think, can help you emerge as a winner in the market.

Securities Industry Development Corp, the leading capital markets education, training and information resource provider in Asean, is the training and development arm of the Securities Commission, Malaysia. It was established in 1994 and incorporated in 2007.

http://www.btimes.com.my/Current_News/BTIMES/articles/SIDC9/Article/


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Rational Thinking about Irrational Pricing

RATIONAL THINKING ABOUT IRRATIONAL PRICING

Depressed investors caused depressed stock market prices. Selling pressure mounts and drives prices down. Investors possessing even modest degrees of aversion to loss capitulate quickly, and the less fearsome succumb soon after. A downward market spiral ensues.

Value investors avoid these scenarios by forming a clear assessment of their averseness to loss. Only having assessed this characteristic honestly do they brave the choppy waters of stock picking.

One way to grasp one’s own loss aversion is to recognize that most people experience the pain of loss as a multiple compared to the joy of gain. The average person greets losses with aversion on the order of about 2.5 times their reception of winnings. The greater one’s loss aversion, the greater value investing’s appeal.

For the most acutely loss-averse investors, pure value investing is most suitable (Graham was extremely risk averse).

Also read:

1. Stock Market Prices
2. Market metrics P/E and Intrinsic value
3. Rational Thinking about Irrational Pricing
4. The Anxiety of Selling
5. Control Value of Majority Interest