What’s the most important factor when you’re trading stocks – making £1,000, or not losing £1,000?
If it’s the latter – and that’s probably most of us – then you are experiencing what is known as loss aversion.
It’s a common issue when you’re buying and selling shares, and it all comes down to basic human psychology: fear is the most powerful motivator of all.
It goes back to our earliest ancestors, hunting for survival, be prepared to flee at the sight or sound of danger. It’s what makes people in a disaster scenario run screaming, trampling over others in their rush to escape.
It’s basic, it’s primeval. And it can seriously affect your ability to trade. After all, if you’re afraid to take a loss, then you would sell your stocks at the first sign of trouble rather than being patient and waiting for the rebound that often follows.
That’s assuming you’ve done your basic homework on the stocks to start with, and they are sound prospects rather than just a punt.
Loss aversion bias and extracting maximum value
Loss aversion can affect your ability to extract maximum value in any trading situation, given the volatility that many stocks experience.
Israeli psychologists Daniel Kahneman and Amos Tversky showed that even something as simple as a coin toss demonstrates our aversion to loss.
In an interview with the New York Times, Dr Kahneman, who won the Nobel prize for economics science, said: “In my classes, I say: ‘I’m going to toss a coin, and if it’s tails, you lose $10. How much would you have to gain on winning in order for this gamble to be acceptable to you?’
“People want more than $20 before it is acceptable. And now I’ve been doing the same thing with executives or very rich people, asking about tossing a coin and losing $10,000 if it’s tails. And they want $20,000 before they’ll take the gamble.”
If this chimes with you, and you think it could be holding you back, US financial planner Carl Richard, author of The Behaviour Gap, recommends taking the Overnight Test.
You buy some stock based on a recommendation by your brother-in-law. Some years pass, and you realise the stock doesn’t fit your investment plan. You want to get rid of it, but you don’t. One night you go to bed, and during the night someone sells the stock and replaces it with cash.
Next morning, you have a choice – you can either buy back the stock for the same price, or take the cash. What would you do?
Most people wouldn’t buy back the stock. Richard believes that by changing your perspective from getting rid of the stock to investing cash, you gain a clearer view of the right course of action.
There’s one particular trading technique used by some of the world’s top financial gurus, including the likes of Warren Buffet, for which overcoming the loss aversion psychology is essential, and it’s called Averaging Down.
If you’re loss averse, you probably think that if you hold shares in a company and they start heading south, then it’s time to get out.
However, with averaging down it could just be the time to buy some more.
It’s a financial trading technique that appears to stand conventional wisdom on its head.
However, it’s actually not as crazy as it sounds. The argument goes that if a stock price is going down, and the fundamentals of the company are still sound, then sooner or later it will rebound.
So if you buy more shares you will reduce the price they need to rebound by in order to start making money.
Some financial gurus have made a lot of money using these techniques, including Benjamin Graham, author of The Intelligent Investor, first published in 1949.
One of the founding fathers of value investing, Graham used the allegory of Mr Market, who comes to the shareholder’s door every day offering to buy or sell shares at various prices – some sensible, some ridiculous.
The investor can either agree with his price, or send him away. Either way Mr Market will be back next day with a different set of prices.
The point Graham was making is that sometimes – quite often, in fact – market prices bear little relation to the real, underlying value of the company they represent. All sorts of things can spook markets, sending share prices tumbling, and they can recover just as quickly a few days later.
Buffett’s best investment
Billionaire investor Warren Buffet has said the best investment he ever made was not a stock, but buying a copy of The Intelligent Investor – he later enrolled at Columbia Business School to take lectures with Graham.
He told investors in his company Berkshire Hathaway: “I can’t remember what I paid for that first copy of The Intelligent Investor. Whatever the cost, it would underscore the truth of Ben’s adage: Price is what you pay; value is what you get. Of all the investments I ever made, buying Ben’s book was the best (except for my purchase of two marriage licences).”
Buffett, perhaps the most famous investor of our day, buys into a company with a weak share price, but whose fundamentals are solid.
If the price continues to fall, he will increase his holding – often several times over. Eventually, when the anticipated turnaround takes place, he will be sitting on a big pile of stock bought dirt cheap that is suddenly worth a lot of money.
It’s important to realise, however, that Buffett is a patient man, and is prepared to hold on for many years before realising his returns. It’s a waiting game –which is why overcoming the loss aversion bias is so vital if you want to use this strategy.
Other big names such as former Fidelity fund manager Peter Lynch have also used averaging down. Lynch was a strong proponent of the belief that falling prices are a good buying opportunity, providing the fundamentals are sound.
He argued a share price fall was “an opportunity to load up on bargains from amongst your worst performers” and that it was “only a tragedy if you sell at that price and never buy more”.
Averaging down example
Let’s take a quick look at some basic arithmetic. Suppose you buy 1,000 shares in Widgets plc at £5. The stock price then falls to £3, and you decide to buy another 1,000 shares. The average price of those shares has now fallen from £5 to £4 (£5+£3 ÷ 2).