What’s more important in trading or investing – 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.
What is loss aversion?
Loss aversion is a cognitive bias that refers to our tendency to avoid losses instead of attempting to acquire equivalent gains. It all comes down to basic human psychology, and fear is the most powerful motivator of all.
It goes back to our earliest ancestors, hunting for survival, being 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 primitive, and it can manifest itself in a number of ways in trading and investing, causing people to make decisions that may cost them money. For example, if a trader is afraid to take a loss, they could sell at the first sign of trouble instead of staying patient and waiting for the rebound that may follow if fundamentals are sound.
Another loss-aversion example is when investors hold on to a losing trade for too long, hoping that they will eventually turn it around. This is often referred to as the sunk cost fallacy, and can prevent people from cutting their losses and in some cases moving on to other opportunities.
Loss aversion in trading can also lead to taking on too much risk in an attempt to avoid losses. This can cause traders to make impulsive decisions, resulting in even larger losses down the road.
By understanding loss aversion and its effects on our decision-making, you can be more mindful of your tendencies and make more informed choices that are in line with your goals and objectives. Understanding loss aversion in economics could potentially help build wealth and reduce inequality across society.
Loss aversion theory explained
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 or investing as well as in business, as people could be too biassed in their approach and miss out on potential opportunities.
How can traders beat loss aversion?
As trading is more concerned with short-term results, the strategies to overcome loss aversion in trading are slightly different to investing. Below is the list of tools and techniques traders could consider to avoid the pitfall.
Note that these strategies are only meant to support your existing trading plan. Always conduct your own research before trading, 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 can 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 can help us to overcome our loss-aversion bias and make better 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
People 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 automatically limits your losses on a trade, which adds discipline and comfort to those concerned about uncontrollable trading losses.
However, stop-loss orders can 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.
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.
How can investors overcome loss aversion?
Luckily, there are strategies that can help to mitigate the cost of loss aversion. However, these would differ in trading and investing as the former focuses on short-term results and price fluctuations, while the latter is typically used for longer term.
Below are some techniques that can be used to overcome loss aversion specifically in investing. Note that these tools are only meant to support your existing investing plan. Always conduct your own research before investing, and never invest money you cannot afford to lose.
Overnight test
When you're thinking about selling a losing stock or a stock CFD, it's important to do your due diligence and research the company thoroughly before making a decision. However, sometimes loss aversion may prevent you from acting on it.
US financial planner Carl Richard, author of The Behavior Gap, recommends taking the Overnight Test.
Imagine you bought a stock based on a recommendation by your brother-in-law. Some years have passed, and you’ve realised the stock doesn’t fit your investment plan. Even though you want to get rid of it, you don’t as loss aversion creeps in. 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 or the stock CFD for the same price, or take the cash. What would you do?
Most people wouldn’t buy it. Richard believed that by changing your perspective from getting rid of the stock to investing cash, you can have a clearer view on the right course of action.
Dollar-cost averaging
There’s one particular technique used by some of the world’s top financial gurus to mitigate the effects of loss aversion, and it’s called dollar-cost averaging.
If you have a lump sum and want to invest in a specific stock, you may be loss averse and think that if you invest a little later the price will become more attractive.
Dollar-cost averaging strategy encourages you to break down the amount of cash across regular purchases of a stock for an equal amount of money, therefore increasing your chances of buying securities at a lower price.
The key here is that the purchase should occur regardless of the asset’s price and at regular intervals. Dollar-cost averaging can also help you to improve your discipline in sticking to an investment plan regardless of the current market conditions.
Averaging down
Another technique is called averaging down, and can help loss-averse investors in the time of market turbulence.
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.
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 may rebound. In other words, averaging down is what’s informally known as “buying the dip” and follows the basic investment principle of “buy low, sell high”.
By using this technique you could cut the average price at which you’ve bought the security in the first place, therefore realising a greater profit if the market value recovers above the new average price. The other side of the consideration is that by increasing your position in a losing trade, albeit at a lower price, the market could keep dropping and your losses will be compounded.
Note that all investment contains risk, and you should always conduct your own due diligence before investing.
FAQs
What are the differences 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 investors would choose more conservative investment vehicles that offer lower risk, such as bonds – although it should be noted that all investments contain an element of risk. Loss aversion, on the other hand, is a behavioural pattern that may affect an individual’s decision-making while investing or trading. For example, when a trader is holding onto a losing position so as not to realise a loss, they are acting under the influence of loss aversion.
What causes loss aversion?
Loss aversion is a psychological phenomenon where people prefer avoiding losses more than acquiring gains. There are many factors that can 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.
