Personal Finance Essentials
Loss Aversion
The Psychology of Investing > Loss Aversion
Most people dislike losses more than they like gains. Those who seek “high returns with low risk” soon discover that no such investment exists. Thus, they refuse to invest, denying themselves the opportunity to accumulate the wealth they need to achieve financial security.
If you want to invest successfully, you must be willing to accept losses as part of the experience. The key is to reduce those losses – which is why diversification and a long-term perspective are so important.
The Coin Toss Experiment
Researchers studying loss aversion ask: if you flip a coin and lose, you lose $100. How much must you be able to win to make this bet worthwhile? The average answer is $200 to $250. This means most people feel losses about twice as intensely as they feel equivalent gains. Some participants demand even more, demonstrating an extreme fear of loss that would cause them to refuse virtually any investment with downside risk.
The Mathematics of Holding On
Loss aversion causes investors to hold losing positions far too long. Consider an investment that falls 50% – from $1,000 to $500. You don’t want to sell because doing so would force you to acknowledge the loss. But consider: the investment must now gain 100% just to return to where it started. And while you wait for that recovery, a better investment might be gaining steadily. Your feeling that “there is no loss until I sell” is not shared by anyone else. The market has already recorded the loss. Acting on facts rather than feelings is the only way forward.