Thinking Fast & Slow. Cognitive biases that trick us. How Loss Aversion harm your long-term returns?

Loss Aversion

This is one of the most powerful concepts in behavioral economics. "It hurts more to lose $X than it feels good to gain $X." This leads to irrational behaviors, such as:

• Holding onto losing stocks for too long (hoping to "break even" to avoid realizing the loss).

• Selling winning stocks too early (to "lock in" the gain and avoid the risk of losing it).

Daniel Kahneman's Thinking, Fast and Slow

The core idea of the book is that our thinking is governed by two systems:

• System 1: Fast, automatic, intuitive, and emotional.

• System 2: Slow, deliberate, analytical, and effortful.

The text highlights how System 1, while efficient, is prone to systematic errors (biases) that significantly impact our judgment, especially in complex areas like investing.

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Summary of the Main Points

The notes outline several key cognitive biases from System 1 that lead to flawed decision-making:

1. Cognitive Ease: We prefer information that is easy to process, which can make us accept familiar or simple statements without critical analysis.

2. Priming Effect: Our thoughts and behaviors can be subtly influenced by unrelated stimuli we've been exposed to previously.

3. Anchoring Effect: We rely too heavily on the first piece of information we receive (the "anchor") when making decisions.

4. Hindsight Bias: After an event has occurred, we tend to believe we "knew it all along," oversimplifying the causes and underestimating the uncertainty that existed beforehand.

5. Loss Aversion: The pain of losing is psychologically about twice as powerful as the pleasure of gaining an equivalent amount. We strongly prefer avoiding losses to acquiring gains.

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Expanded Discussion and Explanation

Here is a clearer breakdown of each concept, explaining how they "trick" us.

1. The Two Systems: The Foundation

• System 1 (Fast Thinking): This is your gut reaction. It operates automatically and quickly, with little or no effort. It's responsible for reading emotions on someone's face, driving a car on an empty road, or knowing that 2 + 2 = 4. While essential for daily life, it often jumps to conclusions based on patterns and shortcuts (heuristics).

• System 2 (Slow Thinking): This is your deliberate, analytical mind. It's mobilized for complex tasks that require focus, like solving a difficult math problem, filling out a tax form, or comparing two products in detail. It's lazy and often defers to System 1 unless specifically engaged.

The Trick: Because System 2 is effortful, we often rely on the quicker, but error-prone, System 1 for decisions that would benefit from more careful thought.

2. Why System 1 Tricks Us: Key Biases

A. Cognitive Ease
This is a state where your brain is on cruise control. When something feels familiar, simple, or easy to process, System 1 gives it a "stamp of approval." This makes you more likely to believe a statement simply because it's repeated, well-presented, or rhymes. The text's line, "You can’t detect a statement of the time," hints at this—we often accept information without verifying it when we're in a state of cognitive ease.

B. Priming Effect
Your recent experiences unconsciously influence your current thoughts and actions. The example given is excellent: if a store plays French music, you might be primed to buy French wine. You're not consciously aware of the influence, but System 1 is guided by these subtle cues.

C. Anchoring Effect
When making estimates or decisions, we give disproportionate weight to the first number we hear. The investing example is clear: if you receive an initial price target for a stock (STSB), that number becomes an "anchor." All subsequent analysis and price judgments are made in relation to that anchor ("your recommendation follows this set to get a new form code after that will be compared to STSB"). This can skew your valuation significantly.

D. Hindsight Bias (The "I-knew-it-all-along" Effect)
This bias rewrites our memory. After an event (like a stock market crash or a successful product launch), it seems to have been inevitable. The text captures this perfectly: "Looking back at it, it looked like the only problem where... But it wasn’t." This is dangerous because it prevents us from learning from past mistakes. If we think we knew what was going to happen, we don't analyze the actual, uncertain factors that were present at the time.

E. Loss Aversion
This is one of the most powerful concepts in behavioral economics. "It hurts more to lose $X than it feels good to gain $X." This leads to irrational behaviors, such as:

• Holding onto losing stocks for too long (hoping to "break even" to avoid realizing the loss).

• Selling winning stocks too early (to "lock in" the gain and avoid the risk of losing it).

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How It Affects Our Investing (Synthesis)

The application to investing is direct and critical:

• Anchoring Effect can cause you to hold onto a stock because you're anchored to the price you bought it at, ignoring new, negative information.

• Hindsight Bias can make you overconfident. If you believe you predicted the last market move, you'll be less cautious about the next one, which is inherently unpredictable.

• Loss Aversion is the enemy of a disciplined investment strategy. It causes you to make emotionally-driven decisions—panic selling in a downturn or being too conservative to enter the market—that harm long-term returns.

• Cognitive Ease might lead you to invest in a well-known, popular company without doing your own deep research (System 2 analysis) simply because the name is familiar.

Conclusion

The notes from Thinking, Fast and Slow serve as a crucial warning: our intuitive mind, while a powerful tool, is riddled with biases that are particularly detrimental in the high-stakes, uncertain world of investing. To become a better decision-maker and investor, you must learn to recognize these biases and consciously engage your slow, analytical System 2 to question your initial instincts, analyze data objectively, and make more rational choices.

Avoidance of loss is the surest way to ensure a profitable outcome.

Be fearful when others are greedy

It can be hard to concentrate on potential losses

• while others are greedily reaching for gains and 
• your broker is on the phone offering shares in the latest "hot" initial public offering. 

Yet the avoidance of loss is the surest way to ensure a profitable outcome.




Stocks do outperform bonds and cash over the years

A loss-avoidance strategy is at odds with recent conventional market wisdom.  Today, many people believe that risk comes, not from owning stocks, but from not owning them.   

• Stocks as a group, this line of thinking goes, will outperform bonds or cash equivalents over time, just as they have in the past.
• Indexing is one manifestation of this view.  
• The tendency of most institutional investors to be fully invested at all times is another.

There is an element of truth to this notion; stocks do figure to outperform bonds and cash over the years. 



Equities are inherently riskier than debt instruments

Being junior in a company's capital structure and lacking contractual cash flows and maturity dates, equities are inherently riskier than debt instruments.

• In a corporate liquidation, for example, the equity only receives the residual after all liabilities are satisfied.  
• To persuade investors to venture into equities rather than safer debt instruments, they must be enticed by the prospect of higher returns.   
• However, the actual risk of a particular investment cannot be determined from historical data.  It depends on the price paid. 
• If enough investors believe the argument that equities will offer the best long-term returns, they may pour money into stocks, bidding prices up to levels at which they no longer offer the superior returns.  
• The risk of loss stemming from equity's place in the capital structure is exacerbated by paying a higher price.

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% 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. 

Conclusion:

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.

Psychology and Investing: Loss Aversion

Loss Aversion

Many investors will focus obsessively on one investment that is losing money, even if the rest of their portfolio is in the black.  This behaviour 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.

"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 since reason." (Philip Fisher, Common Stocks and Uncommon Profits).

Regret also comes into play with loss aversion.

This 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."

We tend to feel the pain of a loss more strongly than we do the pleasure of a gain. 

It is 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.

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

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.

http://news.morningstar.com/classroom2/course.asp?docId=145104&page=5&CN=COM#

Different styles of framing choices causes different preferred outcomes.

Loss Aversion, Risk, & Framing

The next stop in the framing inquiry involves the unique relationship of risk taking to positive and negative framing. Since losses loom larger than gains, it appears that humans follow conservative strategies when presented with a positively-framed dilemma, and risky strategies when presented with negatively-framed ones. To illustrate, consider Kahneman & Tversky's 1984 study where they asked a representative sample of physicians the following question. Read and answer it before you continue.

Imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows: If program A is adopted, 200 people will be saved. If program B is adopted, there is a one-third probability that 600 people will be saved and a two-thirds probability that no people will be saved. Which of the two programs would you favor? 

Be sure to answer this question before you proceed.

Have you answered? OK.

Notice that the preceding dilemma is positively framed. It views the dilemma in terms of "lives saved." When the question was framed in this manner, 72% of physicians chose A, the safe-and-sure strategy, but only 28% chose program B, the risky strategy. An equivalent set of physicians considered the same dilemma, but with the question framed negatively:

Imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows: If program C is adopted, 400 people will die. If program D is adopted, there is a one-third probability that nobody will die and a two-thirds probability that 600 people will die. Which of the two programs would you favor? 

You can see that the two questions examine an identical dilemma. Two hundred of 600 people saved is the same as 400 of 600 lost. However, when the question was framed negatively, and physicians were concentrating on losses rather than gains, they voted in a dramatically different fashion. When framed negatively, 22% of the physicians voted for the conservative strategy and 72% of them opted for the risky strategy!

As you can see, framing the choice positively vs. negatively caused an almost perfect reversal in the choices of highly-trained experts making a decision in their field of expertise--saving (or is that 'not losing'?) lives! Clearly, framing can powerfully influence the way a problem is perceived, which in turn can lead to the favoring of radically different solutions.

Let's consider the same "negative frame => risky behavior" phenomenon from a somewhat less theoretical and more practical perspective. Imagine that you are a medical practitioner, and you have just seen your third case of advanced breast cancer in a single week. "Why," you wonder to yourself, "aren't these women performing breast self-exams (BSEs) and finding these lumps before they become full-fledged, life-endangering metastatic cancers?" Your clinic hands a brochure on BSE to every woman that enters the door, BSE is regularly described in newspapers and on TV; information on this topic isn't exactly scarce! Why do your patients choose to die rather than comply? you wonder.

But consider the act of a BSE. Logically, it's safe--but psychologically, it's a risky procedure. If you perform BSE, you may feel a lump. So performing BSE is a risky behavior, because by looking, you may find something you don't want to find. Not performing a BSE is a logical health risk behavior, but is safer psychologically. By not looking, you won't find anything that may cause you to worry.

Researchers Meyerowitz and Chaiken explored this very question in a 1987 research project. They distributed one of two brochures on BSE to equivalent patients in equivalent clinics. The brochures were identical in terms of content, but one stressed the gains associated with performing a BSE, and the other focused on the losses associated with inaction. You can guess the result, can't you? The negatively-framed brochure lead to higher positive BSE-related attitudes and behaviors. Actually, the true strength of the negative frame emerged four months after patients received the brochures. Those who received negatively-framed brochures showed significantly greater intentions to perform BSE at the later date.

Why is it that negative information causes increased persuasion in these types of situations? Psychologists have long known of the existence of the "positivity bias," which states that humans overwhelmingly expect good things (as opposed to neutral or bad things) to occur. If perceivers construct a world in which primarily positive elements are expected, then negative information becomes perceptually salient as a jolting disconfirmation of those expectations (Kanouse & Hanson, 1972). We also know that people stop to examine disconfirmations to a much higher degree than confirmations. Negative information is often highly informative and thus may be assigned extra weight in the decision-making process (Fiske, 1980; Smith & Petty, 1996). Let me ask you: if you learned that your friend's auto mechanic performed an excellent valve job but botched his automatic transmission repair, would you take your car to that mechanic? No, because negative information overwhelms positive information. You expect a mechanic to be effective, period.

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This topic is considered in further detail for the benefit of my students, who must enter the URLs found on the syllabus to access the following pages (if you're not a student of mine, please don't ask! The answer will be "Sorry."):

• Positive & Negative Frames (They're both effective in the appropriate circumstances, but you need to know which is best to use when.)
• Why Experts Fail to Predict (One reason experts make stupid mistakes.)
• Framing by Position (The real reason for the cheap and expensive models in the product lineup.)
• Framing by Contrast (How contrast is used to make you do things you wouldn't otherwise do.)
• Framing by Attribution (One of the most seductive persuasion tactics around because it makes people feel good!)

Ref:

http://www.workingpsychology.com/lossaver.html

http://www.workingpsychology.com/mediafr.html
Media framing (How the media frames the news and shapes public opinion.)

How Mating and Self-Protection Motives Alter Loss Aversion