Warren Buffet Knows How To Deal With Painful Losses | Loss Aversion

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Warren Buffet Knows How To Deal With Painful Losses | Loss Aversion

How to recognize loss aversion

Remember that stock which you bought that went down by 30%, and you didn’t sell? If you are absolutely convinced that a stock will do well, but then the price falls by 30%, it’s easy to think: “It’s on sale! I’ll invest more” to avoid or delay the loss.

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Loss Aversion

Choose between A or B and if I contact you tomorrow to ask you to honor your bets, you’ll have to do it. ?

So, Option A has an expected value of $50 and B has an expected value of $0. If you are like most people (sorry we’re usually not as unique as we like to think, so I assume you are), you chose option B. Which completely contradicts the rationality set out in expected utility theory (EUT).

What is loss aversion?

One of the reasons you may avoid selling a stock that is down 30% and that you would always chose Option B over A is that losses are painful, they’re more painful than an equal gain makes you feel good. Studies on loss aversion, starting with Kahneman and Tversky’s seminal paper in 1979, have found that you feel a loss 2-2.5 times stronger than an equal gain. This makes you try to avoid more losses, i.e. you are loss averse.

Why is loss aversion a problem?

You take on more risk to avoid sure losses. You keep that stock when it’s down 30% just because you don’t want to realize your loss. If you also follow your instinct that the stock is now on sale after a 30% drop, you may be taking on even more risk. Studies on loss aversion have shown that we’re risk averse when it comes to gains, but risk-seeking when it comes to losses.

For someone new to the stock market that has heard about stocks and stock market crashes, they might also make the choice to park all their money in a saving accounts, not investing at all just to avoid all potential loss. Hence, completely trying to avoid any risk at all just because of the fear of losing.

How to deal with loss aversion

If you have always kept all your money in a savings account until now, you might want to consider investing at least some of it. If you choose to invest in the stock market, unfortunately, you’ll need to bear some risk to get the potential of gaining a return.

If you’re already in stocks, just admit to yourself that you can’t always win. Zero-based thinking can help you, e.g. What if you didn’t own that stock before it fell by 30%, would you buy it now?

Warren Buffett has worked out how to avoid the pain of losses: “Rule #1: Never lose money; Rule #2: Never forget Rule #1.” ?

Stop-loss is a powerful risk management tool. It won’t ensure you never lose money, but the benefit of implementing a stop-loss is that you predetermine your future action and are not making decisions in an emotional state. Like when that 30% loss feels more like a 60-75% loss. Stop-loss helps to preserve capital and protects you from your own emotions.

Article by Alexander Wetterling, Become A Better Investor

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Dr. Andrew Stotz, CFA is the CEO of A. Stotz Investment Research, a company providing institutional investors with ready-to- invest portfolios in Asia that aim to beat the benchmark through superior stock selection. The company also provides buy- and sell-side clients with financial models to value any company in the world and World Class Benchmarking to determine what companies are financially world class. Previously, as Head of Research at CLSA, Andrew was voted No. 1 Analyst in Thailand in the Asiamoney Brokers Polls for 2008 and 2009. He was also voted No. 1 Analyst in Thailand in the 2009 Institutional Investor magazine All-Asia Research Team Report. Andrew earned his PhD in finance at the University of Science and Technology of China in Anhui province, with a focus on answering questions raised by fund managers and analysts during his career about picking stocks and managing portfolios. In addition, Andrew has been a lecturer in finance for 22 years at various universities in Thailand. Since 2013, he has been the president of the CFA Society of Thailand. He is also the author of How to Start Building Your Wealth Investing in the Stock Market.

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