How to avoid the ‘loss aversion’ effect

Do you refrain from selling a losing investment in your portfolio? Or look for only gains on your investment? Then, you need to know what’s the loss aversion effect.

Kavya Balaji   /   October 14, 2020

No one loves losses. Almost all investors hate to look at losses on their portfolio statements. And most of us display more emotions when we make a loss on an investment as compared to when we make a gain. This is called loss aversion effect.

This effect is a behavioural trait that indicates losses and gains are perceived differently by investors. It says that investors are more likely to make investment decisions based on their perceived gains rather than losses. It says that if two decisions are put before an individual, both equivalent, with one being potential profits and the other being potential losses, the previous alternative will be picked.

How did the effect originate?

The loss aversion effect or the Prospect hypothesis was found way back in 1979. However, it was additionally researched in 1992 by Amos Tversky and Daniel Kahneman. Research done by these Israeli therapists on intellectual predispositions and limited objectivity was pathbreaking. Kahneman had won the Nobel prize in 2002 for the work on Prospect Theory.

Tversky and Kahneman recommended that misfortunes cause a more prominent effect on a person than does an identical measure of profits. For instance, suppose you will get Rs. 35,000. One choice is you are given Rs. 35,000 immediately. The other alternative is you gain Rs. 70,000 and you will lose Rs. 35,000. You are getting a similar measure of cash in both the alternatives. In any case, you may be well on the way to decide to get straight money on the grounds that a solitary profit is appearing to be more positive than at first having money and afterwards giving it up.

This behaviour trait is found in investors as well. For investors, holding loss making investment is common as opposed to cutting their losses. Investors are hesitant to sell an investment when it is making losses. They are anxious to sell investments when they are doing incredibly well. This is to book profits to bring in cash.

Here’s an example. Suppose an investment advisor recommends a mutual fund to an investor. He says that the fund’s return is 14% over the past five years. At that point, another advisor recommends the same mutual fund and says that the fund has given better than expected returns. However, the one-year return is low. As indicated by the Prospect hypothesis, the investor is bound to purchase the fund from the first counsellor who said that the fund’s pace of return has been good.

How does this affect investors?

Loss averse investors often lose out on higher profits because of the effect. How? There are people in India who believe that the stock markets are for gamblers. Even some investors who are less than 30 years of age believe that the markets are hazardous. This is a reason given by them as to why they have preference towards fixed-income investments such as bank deposits and government schemes. Along these lines, loss aversion or the dread of losing one’s capital gets people to refrain from investing in equities. This will influence their portfolio returns over the long haul. On the off chance that they don’t pick investments that beat inflation, their real returns will be low.

Another point is investors dismiss their asset allocation because of the loss aversion effect. Typically, when you are young, you can afford to take more risks. However, loss aversion could make your asset allocation skewed. How? Investors who need to invest in equities for their life goals might invest in only bank fixed deposits because of the loss aversion effect. So, they won’t be able to increase their wealth significantly even in a decade, let alone save for their financial goals.

The common mistake that loss averse investors make is not selling a losing stock or mutual fund. So, typically investors wait for the investment to go beyond the price at which they bought it. This may or may not happen depending on several factors such as the investment’s fundamentals, industry environment and market movements. If the investor decides to wait, the price could go down further. If the investor waits for too long to exit or spends more money to buy it to recover losses, then he/she is loss averse. This behaviour will negatively impact their investments. While the investor is waiting, there might be other investments that could provide higher returns. So, loss aversion could lead to wasted time and efforts by the investor.

How to avoid this?

Several investors let their emotional quotient overtake their intelligence quotient. Loss aversion is part of this. Understand that you need to have logic when you choose investments. You need to set aside your emotions and look at the investments objectively. This will help you decide whether the investment is worth holding on to or whether you should be selling it. Cultivating an attitude to taking losses in your stride can help you a good investor. Try to make sure that you don’t repeat your investment mistakes. You should know when to add more money to your portfolio and which investments are likely to do well in the long run.

If you are in doubt, take the help of your consultant at Wealthzi.com.

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