If the human beings were rational in their choices, the outcomes would have been completely different from what we see around. Humans, in general, are quite irrational and irrational in their approach. It is mostly because of the behavioural and emotional biases that they are affected by.
A significant example is how we view our gains and losses. In the rational world, the net effect of total gains and losses must be used to make an evaluated and rational decision regarding the options and choices. However, due to the behavioural biases, humans tend to not process the information in a rational way. We are inclined to value our gains and losses differently.
This is explained by the Prospect Theory in depth. According to the theory, people value their gains and losses differently from each other. When a person is presented with two choices, one with respect to possible gains and the other with respect to the possible losses, he is more likely to choose the one suggesting gains, although the net results of both may be the same. This thought-process leads to the Loss Aversion Bias.
Loss Aversion Bias
The loss aversion bias is a derivative of the Prospect Theory. The individuals with loss aversion bias associate more pain with the losses, compared to the pleasures of the gains. For this reason, they tend to stay away from losses, as much as possible. The bias is rightly summed up as ‘losses loom larger than the gains.’
Due to the loss aversion bias, the investors always prefer to avoid a loss and affect their financial decisions. This can also be translated as the need to play safe all the time. The investor may make profits by taking more risks, but loss aversion makes them risk-averse too. They want to keep what they have, rather than risking it for more.
An example of loss aversion bias, when a trader is presented with the option of choosing between a guaranteed profit of $500 and a riskier bet which can yield either $1000 or $0, the loss aversion bias makes him choose the former option. Thus, he is foregoing his chances of higher profits because he is afraid of losses.
Causes of Loss Aversion Bias
The primary cause of loss aversion bias is the psychological impact associated with profits and losses. The pain of losing money is psychologically twice as compared to the pleasure of gaining money. In order to avoid this pain, the investors become averse to losses.
Even neurologically, the regions of the brain that process value and reward get silenced when the regions of brain that process loss get activated.
Effects of Loss Aversion Bias
Loss aversion bias has a strong impact on the investment decisions of an investor.
Most importantly, the loss aversion bias makes an investor stagnant. It is often considered to be the cause of the status quo bias wherein the investors are resistant in brining any change in their portfolio and remain where they are. This is caused by loss aversion. They do not want to take a risk and let go of what they have and lose it, even though they are giving up on the opportunity to earn more. Gaining more holds less relevance than losing more.
It is also due to the loss aversion bias that the investors keep holding on to their losing stocks for too long. They are unable to accept the loss, and are ready to take higher risks to avoid the negative feelings of the potential loss. The net result, in most cases, is more losses. Therefore, loss aversion bias ends up either in stagnancy or in more losses, rather than relieving the losses.
How to Overcome Loss Aversion Bias?
Loss aversion bias is a cognitive bias. It is deep-rooted into the brains of the individuals, and is therefore quite difficult to get rid of. The human brains are trained and conditioned to react to losses negatively. It is an uphill task to undo the done.
However, with strong counter-conditioning and discipline, the situation can be improved. The investors must make conscious attempts to value gains and losses equally.
When faced with choice between one large gain or multiple small gains, it must be looked at as multiple small gains to maximise the positively experienced. On the other hand, for a choice between one large loss or multiple small losses, it must be looked at as one big loss to reduce the negativity associated with the experience.
Thus, by proper mental training, discipline in trading, and taking advice from the experts, the loss aversion bias can be reduced to a large extent. Once it gets reduced, the trader will be more accepting towards losses and will be able to take riskier and more rewarding investment decisions.