What is loss aversion bias?
Loss aversion is a cognitive bias that refers to the tendency of individuals to experience greater negative emotions and psychological distress when they lose something, as compared to the positive emotions they feel when they gain something. In trading, a simple loss aversion bias definition is that it is the tendency to focus on avoiding losses rather than attempting to acquire equivalent gains.
Loss aversion bias is part of behavioural finance studies, which examines how emotions and other external factors impact economic choices. By understanding it and its effects on our decision-making, you could become more mindful of your tendencies and make more informed choices that are in line with your goals and objectives.
Below, we have loss aversion explained in detail.
Highlights
Loss aversion bias is the tendency to strongly prefer avoiding losses to acquiring gains of equal or greater value, often leading to risk-averse behaviour in trading.
It may occur due to a combination of various factors, including other cognitive biases, negative emotions, and the complexity of decision-making in trading.
It is important that traders are aware of their own biases and make sure they remain objective.
There are various techniques that may help potentially avoid or moderate loss aversion bias, including, among others.
History of loss aversion bias
The term loss aversion was first coined by cognitive psychologists Amos Tversky and Daniel Kahneman in 1979, and is a key component of the prospect theory, for which Kahneman won a Nobel prize in behavioural economics.
Prospect theory has important implications for trading and investing and has created a whole new field of study known as loss aversion behavioural finance.
While traditional economic theory states that we make rational decisions based on self-interest, Tversky and Kahneman revealed that other factors such as fairness, past events and aversion to loss also play an important role.
In the prospect theory, researchers showed that the probability of perceived gain is preferred much more by individuals than the probability of a perceived loss. In other words, when choosing between earning $50 or earning $100 and then losing $50, we are more likely to go for the former, even though the two scenarios lead to identical outcomes.
This is because the pain of a loss is twice as powerful compared to the joy of an equivalent gain. This problematic psychology may lead to poor decision-making when trading.
Why does loss aversion bias happen?
The reasons behind this behavioural bias are extensive and could be caused by a variety of psychological, social, cultural, and market factors. Some of those are:
Evolutionary psychology: Our brains have evolved to prioritise survival in the face of danger. This means we tend to place more emphasis on avoiding losses than achieving gains.
Social and cultural factors: In many cultures, there is a stigma attached to losing money. This may create a fear of failure and a reluctance to take risks.
Negative emotions: Losing money can be a stressful and emotionally taxing experience. When traders experience losses, they may feel anxiety, regret, and other negative emotions.
Cognitive biases: There are many cognitive biases that could contribute to loss aversion bias. For example, confirmation bias may cause traders to seek out information that confirms their pre-existing beliefs about the market, while ignoring up-to-date information that contradicts those beliefs. Anchoring bias may cause traders to anchor their decisions to a particular price or value, making it difficult for them to adjust their strategy when conditions change.
Market volatility: The nature of financial markets could also exacerbate loss aversion bias. The volatility and uncertainty of the markets may make traders more prone to emotional decision-making and irrational behaviour. The fear of missing out on potential gains could also contribute to loss aversion bias, as traders may hold onto losing positions in the hope that they would eventually turn around.
Examples of loss aversion bias
To better understand the concept, let’s take a look at the example that demonstrates how loss aversion bias can affect decision-making in everyday situations.
Imagine a person who is considering whether to buy a new car or keep the old one. Their current car requires frequent repairs and maintenance. The new car is much more efficient and reliable. However, driven by loss aversion, the person decides to keep the old car due to the fear of losing the money they have already invested in it, even though the cost of maintaining it may be greater than the cost of the new car.
In trading, loss aversion can take on several forms. Below are hypothetical situations that demonstrate how the bias could manifest itself in one’s decision-making:
A trader holds a long position on contracts for difference (CFDs) on Meta (META) shares. The stock starts to fall. Driven by loss aversion, the trader becomes overly attached to a losing position. Even though the market shows clear signs of the start of a prolonged bearish trend, they refuse to cut losses by closing their position and decide to keep it open until the position recovers. The stock, however, continues to fall, and the trader experiences even larger losses. Such a behaviour is often referred to as the sunk cost fallacy.
A trader decides to go short on Dow Jones (US30) Index CFDs. The market moves against them, with the index hiking progressively higher throughout the day. The trader becomes overly aggressive in an attempt to make up for losses. They open several trades in different assets without doing thorough research, taking excessive risks instead of adhering to the risk management plan they have established. Apart from potentially bigger losses, this leads to more frequent trading and higher transaction costs.
In the past, a trader opened a long position on EUR/USD CFDs. Due to a number of factors, they experienced a loss. As a result, they become overly fixated on the loss they have recently incurred, leading them to make decisions based on fear rather than market trends and analysis.
How to overcome loss aversion bias
There are a few strategies that could potentially help mitigate the cost of loss aversion. Below, we list some of the tools and techniques.
Note that these strategies are only meant to support your existing trading plan. Always conduct your own research before making a trade, and never trade money you cannot afford to lose.
Having a well-defined exit strategy
When we're faced with the possibility of a loss, our natural inclination is to do whatever we can to avoid it. This could lead us to make decisions such as closing a winning position too early or holding onto losing trade for too long.
A well-defined exit strategy could help us to overcome our loss-aversion bias and make informed decisions. Traders can use various tools from technical or fundamental analysis to optimise their exit strategy.
By having a clear plan for when to sell an asset, you can take the emotion out of the decision and make it based on objective criteria. This can help you avoid the costly mistakes that loss aversion can lead to.
Use stop-losses and limit orders
Traders use stop-loss orders and limit orders to try to minimise their losses. A stop-loss order is an order to sell a security when it reaches a certain price, and is designed to help limit a trader's loss on a position. Having a stop loss can limit your losses on a trade, which adds discipline and comfort to those concerned about uncontrollable trading losses.
However, stop-loss orders could also have some drawbacks. First, they can be triggered by normal price fluctuations, and the investor may end up selling the security for less than intended.
Second, stop-loss orders may not always be executed at the desired price, particularly in fast-moving markets. So while stop-loss orders can be a helpful tool for managing risk, they should be used with caution, as they may not be guaranteed.
Automate your trading
Some people are turning to automation with trading robots to help them overcome their loss aversion. With a trading robot, you can set clear parameters for what you’re willing to lose on a trade.
This can take the emotion out of the decision-making process, and help you to stick to your plan. What's more, a trading robot can help you to discipline your trading and force you to take a more systematic approach. With a little help from technology, you can overcome your natural tendencies and make more informed, rational decisions.
Note that all trading contains risk, and automation shouldn’t be used as a substitute to your own research. Always conduct your own due diligence, and never trade money you cannot afford to lose.
Conclusion
Loss aversion bias in trading is a cognitive bias that could cause traders to place more weight on avoiding losses than on seeking gains, which could lead to suboptimal trading decisions.
Loss aversion is often caused by emotions such as fear, anxiety and regret. Driven by the bias, a trader may choose to hold onto losing positions for too long in the hope that it will eventually turn around, even if the fundamentals suggest otherwise, or to sell winning positions too soon, in an effort to avoid potential losses.
One of the keys to overcoming loss aversion bias could be to try to be objective and flexible, and to be able to evaluate market conditions and make decisions impartially, regardless of what your current position is. By recognising and addressing this bias, traders could make better decisions and potentially improve their overall performance.
FAQs
What does loss aversion mean?
Loss aversion refers to the tendency of individuals to feel the pain of losses more strongly than the pleasure of gains. It is a cognitive bias that could impact decision-making, making individuals more risk-averse and cautious in their actions, in an attempt to avoid potential losses.
What is an example of loss aversion?
A loss aversion bias example could be a trader who holds onto a losing position for too long in an effort to avoid realising the loss. For instance, a trader goes long on META stock at $200 per share. After a few days, the stock drops to $150 per share. Rather than closing the position, the trader holds onto it in the hopes that the stock’s value will increase, even though the value is at that point, considered unlikely to return to its original purchase price.
What is the difference between loss aversion and risk aversion?
There are a few key differences between loss aversion and risk aversion. Risk aversion is a general bias towards safety and against uncertainty. Risk-averse traders would choose more conservative trading vehicles that offer lower risk, such as bonds – although it should be noted that all instruments and markets contain an element of risk.
Loss aversion, on the other hand, is a behavioural pattern that may affect an individual’s decision-making while trading. For example, when a trader is holding onto a losing position so as not to realise the loss, they are acting under the influence of loss aversion.
What causes loss aversion?
There are many factors that could contribute to loss aversion. For example, people may be more likely to avoid losses if they grew up in a family or culture that emphasised avoiding losses. In addition, people who have experienced losses in the past may be more loss averse than those who have not.
