Let’s say next week you make a profit of $1,000 in the market. And the following week, you lose $1,000.
Of course, making money was better than losing money. But was the joy of winning greater than the pain of losing?
For most people, it isn’t – losing feels worse. The thrill of victory pales next to the agony of defeat. The fish that got away looms larger in the fisherman’s mind than the one that landed in the frying pan.
But the human reaction for the pain of defeat to sting more than the delight of victory messes with our emotions. And that can lead to bad investment decisions.
The way our brains perceive loss (“giving back” to the market) is crooked. Research suggests that our minds experience actual physical pain when losing money. And studies have shown that the pain we feel while losing, is greater than the pleasure that we feel when we’re winning or gaining an equal amount.
This is “loss aversion”
This is called loss aversion. In investment terms, it means that people over-exaggerate the risks of a particular investment, even if the odds are in their favour, and decide to play it safe. So even if the chances of making $1,000 are better than losing $1,000 in an investment, many investors will avoid the opportunity altogether. Most people exaggerate the smaller possibility of a worst-case scenario, and as a result do not participate in what is, statistically, a good opportunity.
An experiment involving $50 and a coin toss demonstrated this. Scientists handed subjects a $50 bill and gave them two options: Keep (or “win”) $30, or toss a coin to make, or lose, $50. In the experiment, 43 percent of the subjects chose to gamble, and the rest “won” (or kept) the $30.
Then the experiment was repeated, and participants were again handed $50 and again were given two options: “Lose” $20, or toss a coin to make or lose $50. Note that the actual outcomes of the two different experiments were identical – “winning” $30 of the original $50, or “losing” $20 of the original $50. The difference was in how the outcomes were framed: “Losing” $20, or “winning” $30.
When the option was framed as “losing” $20 rather than “winning” $30, 61 percent of the group chose to gamble. The desire to avoid a loss, rather than go with the easy profit, pushed participants to make a poor choice.
Two ways to fight risk aversion
What can you do to avoid making a bad decision because of loss aversion? Two things.
First: Try the overnight test.
Let’s say you invested in a stock (or any other asset) that has declined in value. Now you’re faced with a decision to sell at a loss, or continue to hold. It’s painful admitting you were wrong, of course.
But imagine you went to sleep, and overnight the asset was replaced with cash. Ask yourself: In the morning when the markets open, would you now buy the stock (or whatever asset) at the current market price – or invest that money somewhere else?
If you wouldn’t buy the stock even at this lower price… you should probably sell.
(When I took over the management of a hedge fund a number of years ago, my boss told me to do just that … he said, “I’d like you to look at every position in the portfolio. Learn the story and why it’s in the portfolio. And then ask yourself if you would buy it today, right now. Because by having it in the portfolio, that’s what you’re doing.” That helped prevent me from taking losses… or looking for gains… in an emotional way.)
Second: Use trailing stop losses. I talk about this all the time. It’s when an order “trails” a rising stock by always resting a pre-determined amount (either a percentage or an absolute figure) below the stock’s most recent high (that is, since you’ve owned it). It’s one of the most basic ways to limit your losses and take the emotion out of investing. But like a lot of the best advice (“get enough sleep,” “exercise every day,” “eat less”), it’s not easy to follow – precisely because emotions take over.
And that… would be your loss.