Loss Aversion

Loss AversionSocial scientists have proven that—emotionally—a loss “weighs” at least twice that of a similar gain.  That might be great for aspiring body-builders, but not so great for us regular Joes.

It’s the actual gaining or losing and your feelings about it that matters more to you, rather than how those gains or losses leave you overall.

This asymmetry between the power of positive and negative expectations or feelings has an evolutionary history (very often the root cause for “strange things” happening in our brain). Organisms that treat threats as more urgent than opportunities have a better chance to survive and reproduce.

Example: People were asked whether they could save 20% of their income.  Only 50% said yes.  But when people were asked whether they could live on 80% of their income, 80% said yes.  To save 20%  is to lose that amount from your disposal income.  But to live on 80% of your income is to do without what you would gain from that last 20%.

Another example on how to manage this bias: Do not sell stocks that have risen in price and hold onto losing stocks.  Instead, (in nautical terms) you should stick with boats that have proven their seaworthiness and abandon ships that already have leaks.

Cut your losses short.  Otherwise, your loss aversion is costing you money!  Even worse, it makes you too ready to throw additional good money after bad.

Loss aversion also means that people are a lot happier when they are right frequently. What’s interesting is that being right frequently is not necessarily consistent with an investment portfolio that outperforms its benchmark. The percentage of stocks that go up in a portfolio does not determine its performance; it is the dollar change in the portfolio.

Investors must constantly look past frequencies and consider expected value contrary to our natural loss aversion bias.

To the brain, loss is a threat, and we naturally take measures to avoid it. We cannot, however, avoid it indefinitely.

One way to face loss is with the perspective of a stock trader.  Traders accept the possibility of loss as part of the game, not the end of the game.  What guides this thinking is a “portfolio” approach; wins and losses will both happen, but it’s the overall portfolio of outcomes that matters most.  When you embrace a portfolio approach, you will be less inclined to dwell on individual losses because you know that they are small parts of a much bigger picture.

Now of course this knowledge that the fear of losing money motivates people more than the prospect of gaining something of equal value can be used to your advantage.  Suppose you are in sales.  You tell your customers how much money they are losing—by not using your products—instead of how much money they could save by using them.

Awareness of biases is the first step to avoiding them and then hang in there.loss aversion frogs

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