Investors’ Behavioral Biases: Part III – Loss Aversion
Loss aversion is thought to have developed in the early years of human evolution. An earlier time when the loss of resources, such as food, fire or life, had much more serious consequences that an incremental gain. Thus a loss is felt much more acutely than a gain.
Loss aversion also explains two other human traits, the endowment effect and sunk cost fallacy. In the former a person places a higher value on an item they own than an identical item they do not own. The sunk cost fallacy is where humans continue a behaviour as a result of previously invested time, effort or money.
Investors are particularly susceptible to loss aversion. When we buy a stock in the expectation (hope) of gain, we have committed money and our decision-making ability. Should the stock go down we will try to justify holding on to it. The classical trade that becomes a long term investment. Even worse is to average down.
The tendency to keep holding the stock is to avoid realising a loss. While it may be irrational, it is hard wired in the human brain. To avoid succumbing to this bias many investors will institute a stop loss so emotions don’t come into play. Most successful investors would put cutting losses at the top of any list of trading rules. So understand your biases, as once you are aware corrective action can be taken.