Don’t Lose Out To Loss Aversion

No one likes losing and will do anything to avoid it. When it comes to investing, losing hurts more and that leads us to situations that are not rational, such as holding on to losses in the hope of regaining our capital. This phenomenon or behavioural bias is known as loss aversion. As investors, we all think we are rational, but the truth is, our brains are wired to hate losing more than to enjoy winning.

What is Loss Aversion?

Loss aversion is a concept that was introduced by behavioural economists Daniel Kahneman and Amos Tversky. It refers to the tendency of people to prefer avoiding losses over acquiring equivalent gains. Simply put, the pain of losing Rs 100 is almost twice as powerful as the pleasure of gaining Rs 100. The reason we are so averse to losing is that we feel the pain of loss more acutely than we feel the pleasure of gain.

In investing, this leads to emotional decisions, such as panic selling when there is volatility in the market, holding on to bad investments, or avoiding risk altogether. But none of these reactions will serve your long-term financial goals.

For instance, after the sharp Covid-related crash in March 2020, a large number of investors exited from equity, fearing further fall in the market. Ironically, the markets bounced back within months, and those who stayed invested saw strong gains. The fear of further loss caused many to miss out on the recovery.

Another classic example of loss aversion is where investors hold on to bad investments in the hope of a rebound. Take the case of some Yes Bank investors. When Yes Bank shares began crashing in 2019, many retail investors held on. Even when it dipped below Rs 20, they refused to book their losses, clinging to the hope that prices would recover to their cost price or higher.

How Does It Affect You?

The result? Many held on too long and ended up with even deeper losses. Take the case of Siddharth Sharma, 39, a compliance officer at a pharmaceutical company in Mumbai. He continues to hold Yes Bank shares despite the downturn.

“I bought Yes Bank shares at Rs 220. When news broke about the departure of the bank CEO and the stock fell to Rs 150, I bought more to average out my cost. Then all the other issues followed. I am still holding on, hoping that someday it will bounce back to my buying price and only then will I sell,” he says.

Even if he had sold the shares at Rs 150 by incurring a loss of Rs 70 per share and reinvested the amount in other quality stocks, he would likely have made a profit by now.

As investors, our instincts are not always our allies. Loss aversion may feel natural, but it often leads to poor decisions. The key is to recognise the bias and push past it with logic, selection of the right instrument and patience. So, the next time you are itching to sell during a downturn or avoiding equities because of past pain, ask yourself: Am I protecting my money or just protecting my feelings?

Once you learn to manage loss aversion, you don’t just become a smarter investor, you would become a stronger one.

How To Overcome Loss Aversion?

The first step is to identify if you are loss averse. If you fear loss more than you like gains, you are loss averse.

Manage your emotions by treating notional losses in market instruments as a symptom of volatility, not permanent loss.

When investing in the markets, it’s always best to focus on long-term goals. That will help you not let short-term dips derail your emotions.

If you think you refuse to sell bad investments or are fearful of equity investments because of past losses, you are likely loss averse.

Assessing why a particular asset is in the red will help you understand whether to stay put or exit it instead of getting guided by emotions.