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Loss Aversion (Emotional Bias)

Some of us are highly loss averse, but in general we’re all averse to losses to some degree. Empirical estimates find that losses are felt between two and two-and-a-half as strongly as gains. Thus the disutility of losing $100 is at least twice the utility of gaining $100. Evenutally loss aversion favors inaction over action and the status quo over any alternatives.

Therefore we avoid making investment decisions because we’re afraid we’ll make the wrong choices. We hang onto beaten-down stocks because it's too painful to sell and make those losses “real.” That’s not unusual. People tend to work harder to avoid an impending loss than they do to achieve a gain.

Even more interesting: While the average person is two times more averse to losses compared to how much they value gains, retirees are five times more sensitive to loss, according to a study by AARP and the American Council of Life Insurers. This makes sense, given that the closer you are to retiring, the harder it can be to shrug off a market loss because you have less time to recover.

Loss Aversion and Investments

Not everyone has an equally hard time coping with loss, of course. Personality traits such as optimism and confidence can override the aversion, just as worry or pessimism may accentuate it, according to Victor Ricciardi, co-editor of Investor Behavior: the Psychology of Financial Planning and Investing.

Experience also plays a role: Investors who have lived through several bear markets and severe shocks to the stock market may also have a more pronounced negative response to loss, he says.

The upside of loss aversion

But not all loss aversion is bad. If you’re near retirement or are already in pension, reducing investment risk—and potential losses—might be a good decision. “The performance of your portfolio just prior to and in the early years of retirement can have big effects on the success of your financial strategy,”

Conclusion: Recognizing loss-aversion as part of the natural human reaction to uncertainty will help you stay on target as you lay out your investment-strategy.

Important quotes

"The central assumption of the theory is that losses and disadvantages have greater impact on preferences than gains and advantages." Tversky and Kahneman (1991)

"Numerous studies have shown that people feel losses more deeply than gains of the same value (Kahneman and Tversky 1979, Tversky and Kahneman 1991)." Goldberg and von Nitzsch (1999) pages 97-98

publication-download: Kahneman Publication (.pdf)

"In prospect theory, loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Some studies suggest that losses are as much as twice as psychologically powerful as gains. Loss aversion was first convincingly demonstrated by Amos Tversky and Daniel Kahneman."

link: Loss aversion-wikipedia

further source: Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias by Daniel Kahneman, Jack L. Knetsch, Richard H. Thaler; The Journal of Economic Perspectives, 5(1), pp. 193-206, Winter 1991