Dubai: It’s common for any investor to wish being better off holding onto a profitable investment for a tad longer or selling a money-losing asset slightly sooner. While this comes with the ever-present struggle of timing the market, experts also attribute this to what’s called the ‘disposition effect’.
“The ‘disposition effect’ theorises that losses — whether in the stock market, real estate, or other domains — have far more emotional impact on us than equivalent gains,” explained Matthew Griffin, a UK-based behavioural economist. “It’s often linked to an aversion of losses.
“Telling yourself to stop trying to avoid the pain of regret is about as effective as telling yourself not to think about an elephant. But that doesn't mean you're destined to spend your life fighting the disposition effect.”
So investors with such a bias prefer to avoid a loss than to make an equivalent profit. When faced with a choice of avoiding a loss of Dh1,000 or making a profit of Dh1,000, investors with loss aversion bias will prefer not making a loss to making a profit.
Aversion to losses influences money-making mentality
A significant amount of research has been conducted in order to understand how investors process loss and they have found out that most investors have an innate aversion to losses. This causes them to make wrong decisions while investing.
It’s the ‘disposition effect’ or ‘loss aversion bias’ drives a lot of investment decisions. “Investors often become not just emotionally involved with their investments, but also form a psychological attachment. This is the reason that they see a financial loss as a personal failure,” added Griffin.
So while investors should ideally get about the same amount of joy from earning Dh500 as compared to the pain they would get while losing Dh500, studies reveal that that the pain of losing money is actually far greater than the joy of earning money.
‘Disposition effect’ causes irrational investment decisions
“Often times, it is when investors want to stay clear of the pain of such losses that they make a lot of irrational investment decisions,” said Brody Dunn, an investment manager at a UAE-based asset advisory firm. “This is a direct result of the ‘disposition effect’ or ‘loss aversion bias’ on investors.”
So what do investors do when they are irrational or averse to losses? Here’s an example: When stock markets worldwide drop, financial planners have noticed it’s at that point of time when people start to get concerned, especially people who are near retirement or in retirement.
Another example is when people are so fearful they avoid getting into the market at all, perhaps being scared to start investing because any potential losses might mean he or she will be back to struggling financially.
“Ultimately, irrational investment decisions boil down to a fear of losing the money you worked hard for, and the fear of not being able to ever get it back. This is when financial planners and investment advisors reiterate that investing is always done with the long-term in mind,” added Dunn.
How to beat the ‘disposition effect’ or ‘loss aversion bias’?
If you are new to investing, there are a couple of crucial steps you can take to help you keep potential fear of losses in check and stop yourself from taking irrational investment decisions, according to Dunn and Griffin.
1. Don't make investment buy or sell decisions on your own
“First and foremost, find and follow a proven investment objective and a rule-based investment selection process, especially when you’re new to the world of investing,” added Dunn. Prevent yourself from looking at your investments so often.
Research by market psychologist Paul B. Andreassen, an Associate at Harvard University, found that people who receive frequent updates about their investment portfolios tend to trade more often and generate poorer returns than those who receive less frequent updates.
“Watching the daily gyrations of the market is a prescription for heartburn and bad decision-making. Check in with your holdings once a quarter, or once a month if you must. If you signed up for daily or weekly updates on how your portfolio is doing, today's the day to unsubscribe,” added Griffin.
2. Routinely modify your investment goals and time frames
Dunn further advised that by creating and writing out an investment plan and identifying your investment goals and time frames, you are committed to sticking to it under various market conditions.
“This involves detailing out the strategy you're using to accomplish them, the process you're following for choosing specific investments, and perhaps most importantly, what you plan to invest in till when. Then review it anytime market conditions tempt you to veer from your plan,” he added.
“As an investor, while it’s only natural in wanting to monitor how your investments are doing, it’s not a good idea to always know how your portfolio is performing, because frequently adjusting your investment strategy and constantly trying to maximise your profits raises the risks of losses.”
For many, investing is how money is saved for retirement, college education and other life events. After setting financial goals and building a diversified portfolio, investments grow over time. But as the years go by and situations change, there may be a need to adjust those investments.
When it comes to deciding between buying or selling investments, ‘the disposition effect’ or ‘loss aversion bias’ can come into play. “Are you planning to take profits by selling some profitable investments or are you planning to hang onto investments that haven't done well?” added Griffin.
“If you are, there’s reason for caution. You may be under the spell of what behavioural scientists call the ‘disposition effect’. That's the tendency to sell winning investments too soon and keep losing investments too long.”
Renowned Canadian economist Hersh Shefrin, one of the behavioural finance experts who identified the ‘disposition effect’, described it as a "predisposition towards getting even”, where instead of cutting your losses, you would rather tend to hang on in the hope of at least getting back to even.