How “Loss Aversion” Can Cripple Your Portfolio (And What To Do About It…)
On the surface, being a long-term investor seems like it should be pretty easy. You simply find a stock you like, buy it, and hold it for the long haul. But in reality, this is not an easy undertaking.
This may give my readers pause. After all, the primary goal of my premium newsletter — Top Stock Advisor — is to grow our wealth through purchasing great companies at fair prices. These are usually the kinds of stocks that can be held for the long haul, not merely for days or weeks or months.
But the truth is that in today’s information-filled age, it’s sometimes psychologically tough to weather the storm.
Think about it: On any day of the week you can probably find an article or two that will tell you why you should sell XYZ stock. On the flip side, you can probably find a reason why you should buy that same stock. Perhaps this is the reason why the average holding period for stocks has plummeted from about eight years in 1960 to just a few months today.
One of the reasons for the higher turnover rate can likely be attributed to how cheaply and easily we can place trades through online brokerage platforms compared with the 1960s. Or perhaps it’s because of how quickly we can access information regarding a stock that can make us second-guess our investment.
But a far more likely culprit is something that’s ingrained in our DNA. Specifically, there’s a part of our brain called the amygdala — this is the part that’s involved with experiencing emotions. In this case, the fear of loss.
Loss Aversion, Explained…
To help prove this point, consider this scenario from Credit Suisse that I read about a few years ago when they addressed this problem.
Imagine you have to choose one of the following options:
- Option A: A sure gain of $10,000.
- Option B: Playing a lottery with an 80% chance of winning $12,500 and a 20% chance of winning nothing.
Which would you choose?
Most people would choose option A. But as Credit Suisse says, “From a purely rational perspective, the two options have an identical expected gain, but option B is clearly more risky. And this additional risk tends to drive most people toward option A. The chance of winning an extra 2,500 dollars compared to the safe option is not worth the risk of winning nothing. This is a reflection of risk aversion, and it means that investors are only willing to take on additional risks if they are adequately compensated for it in the form of higher returns.”
Now let’s take a look at another situation.
- Option A: A sure loss of $10,000.
- Option B: A lottery with an 80% chance of losing $12,500 and a 20% chance of losing nothing.
In this instance, most folks would choose option B. However, if you chose option A in the first scenario, logic would dictate that you choose option A again in the second one. That’s because option B is riskier while offering the same expected return. Yet, by simply switching from possibly making money to possibly losing money, most investors switch from being risk-averse to risky.
What This Means For Investors
The two scenarios demonstrate what is known as “loss aversion”. This is the natural tendency to avoid losses whenever possible… even if it means risking an even bigger loss.
The fear of loss has an unquestionable impact on our investing decisions. The pain of losing is thought to be psychologically about twice as strong as the pleasure of making a profit. This means we’re likely to hold onto a losing position for far too long… and subsequently we cut our winners too short in fear that we might lose any gains we’ve made so far.
Don’t get me wrong — loss aversion can be useful. After all, it does trigger the emotion of fear and anxiety that helps humans survive potentially life-threatening situations. But when it comes to investing, loss aversion can be devastating to your overall performance.
For example, constantly reading and checking up on your investments can lead to a myopic approach to loss aversion. Perhaps you read something that says you should sell XYZ stock immediately, or you don’t feel the stock is performing as you think it should from when you checked it a few days earlier. So you decide to sell the stock, causing you to potentially miss out on any significant long-term opportunities that it may have provided.
Action To Take
Look, I know most of you come here to read commentary on the market and get stock ideas. But gaining a better understanding of loss aversion and investor behavior in general are vital to investment success. This will help you do a better job of keeping your emotions in check. And having this awareness can be especially beneficial during times like these.
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