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What is Loss Aversion and Why You Should Avoid it at All Costs

Loss Aversion Dilbert - Vintage Value InvestingOctober 15, 2014 was a rocky day for investors in the stock market, which at its lowest point dipped 460 points, close to “correction” status. A late-day rally saw stocks rebound, ending the day down 173 points at 16,142. Some investors decided to weather their losses, betting that the market turbulence would eventually settle. Others panicked and dumped stocks.

That, history tells us, was a mistake.

Which Investors Had the Biggest Losses?

An analysis from SigFig, an investment planning and tracking firm, looked at how investor behavior that volatile day almost 3 years ago affected their long-term performance. They found that about 20% of investors decided to reduce their exposure to equities, mutual funds and ETFs, with some selling 90% or more. Those were the investors with the worst performance. As the SigFig researchers point out:

“Those who appeared to panic the most—for example, those who trimmed their holdings by 90 percent or more—had the worst 12-month-trailing performance of all groups. Their portfolios delivered a trailing 12-month return of -19.3 percent as of Aug. 21, compared with -3.7 percent for the people who did nothing during that October correction.”

The Consequences of Panic Selling Are Almost Always Bad

Reacting emotionally to sudden shifts in the market typically has negative consequences. Investors who tend to panic when stocks move lower are simply locking in their losses rather than avoiding the them.

A recent study from University of Missouri professor, Rui Yao, sought to examine this phenomenon by looking at the behavior of investors during the economic downturn of 2008 in granular detail. Among her findings was that the more vulnerable investors were, the more they tended to panic, and the more they tended ultimately to lose. For example, those who had been laid off or didn’t have an emergency fund were among the first to begin selling. Yao also found, however, that many who were not especially vulnerable yielded to the same “panic/sell” error:

“If you were laid off and don’t have an emergency fund, that’s one thing. But these are people who don’t have immediate consumption needs and aren’t harvesting losses for tax reasons. They shouldn’t be moving into cash.”

So, why would someone who is financially well-off behave in the same way as someone who is economically vulnerable? The predictive factor which linked the two groups, according to Yao, was not a financial variable, but a psychological one: “loss aversion.”

What Is Loss Aversion?

Scientific American describes loss aversion this way: imagine a friend challenges you to a betting game (check out: Steven Crist on Value Investing and Horse Betting). Winners and losers are determined by the flip of a coin. If it lands on heads, you gain $20. If it lands on tails, you lose $20. Studies have found that for most of us, the amount you could win would have to be double the amount you could lose for you to take that bet.

In other words, the psychological impact of potential losses is about twice as powerful as the impact of potential gains of the same size.

Prospect Theory: Behavioral Economics

In 1979, psychologists Amos Tversky and Daniel Kahneman (author of highly recommended book: Thinking, Fast and Slow) released a groundbreaking study, “Prospect Theory: An Analysis of Decision under Risk.” That analysis applies loss aversion theory to the financial choices people make, like whether to sell or hold on to stocks during a market downturn. Investopedia describes prospect theory as follows:

“Prospect theory assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses. Also known as “loss-aversion” theory, the general concept is that if two choices are put before an individual, both equal, with one presented in terms of potential gains and the other in terms of possible losses, the former option will be chosen.”

The Neurological Underpinnings of Loss Aversion

A 2007 study from Russell A. Poldrack, a professor of psychology at Stanford University, looked at loss aversion behavior at the neural level. Monitoring the brain activity of study participants deciding whether or not to take a gamble with actual money, he and his fellow researchers found that the regions of the brain which process value and reward are more “silenced” when individuals evaluate a potential loss than they are activated when they assess a similar-sized gain. Poldrack summarizes their findings in this way:

“We found enhanced activity in the participants’ reward circuitry as the amount of the reward increased and decreasing activity in the same circuitry as the potential losses accrued. Perhaps most interesting, the reactions in our subjects’ brains were stronger in response to possible losses than to gains—a phenomenon we dubbed neural loss aversion.”

What Does This Mean for Your Investments?

It’s human nature in some instances to take actions which are not in our best interest—but the impact of yielding to self-destructive impulses can be devastating when applied to key investment decisions. So remember: Smart value investors base their financial decisions, in the market and elsewhere, on reliable data, not emotion.

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