How aversion to losses influences money-making mentality among stock investors. Investors monitor stock prices at a brokerage in Beijing. Image Credit: AP

Dubai: Loss aversion is a trait of investor behaviour wherein investors 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.

Loss aversion fallacy will cause the investors to hold on to the stocks despite there being no future for them. Loss aversion often causes investors to take a lot of unnecessary risks. For example, if investors face a loss, instead of accepting the loss, they often try to gain from it.

Behavioural financial analysts have conducted a significant amount of research in order to understand how investors process loss. In the process, they have found out that most investors have an innate aversion to losses. This causes them to make wrong decisions while investing.

The pair who coined the term in 1979, Israeli-American psychologist Daniel Kahneman and Israeli mathematical psychologist Amos Tversky, said loss aversion is when “losses loom larger than gains”.

How does loss aversion affect investors?

When the market gets volatile as it did in early 2022, some investors evidently start to get antsy. Some of the world’s biggest stock markets ended January lower amid concerns about inflation, the ongoing COVID-19 pandemic, and potential interest rate increases braced for worldwide.

The average stock market return is about 10 per cent per year; sometimes its lower, sometimes much higher. But financial planners advise investors not to try to time the market and not jump out on a bad day. If people are still buying stocks when the market dips, that's a good sign.

Although markets will have down periods, history proves the market will recover. So while the fear of losing money in the stock market is understandable, knowing the market's history may make staying invested more attractive than jumping out.

An old adage among stock market investors is, “While there are two rules when it comes to financial market investing, one being, ‘Don’t lose money’, the second rule is to not forget the first rule.”

This saying explains the psychology that drives a lot of investment decisions. Investors often become psychologically involved with their investments. This is the reason that they see a financial loss as a personal failure.

For instance, ideally, investors should get about the same amount of joy from earning Dh500 as compared to the pain they would get while losing Dh500.

However, researchers have conducted studies and concluded that the pain of losing money is actually far greater than the joy of earning money. This is the reason why investors make a lot of irrational decisions in order to avoid that pain.

Stock chart
How does loss aversion affect investors?

What do investors do when they are irrational or averse to losses?

One example is when investors start worrying when a stock market benchmark that tracks an index dips, and money 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, it boils down to that fear that you could lose this money that you worked hard for, and you're not going to be able to make it back. But investment planners often reiterate to their clients that investing is for the long-term. Here’s a detailed look at some more examples, apart from the above:

• Early profit booking

A lot of investors are fixated on finding winning stock. This is the reason that if they invest in a stock and it rises even slightly, then the investors want to book their profits and exit the investment.

What is a winning stock?
Winning stocks are ones that prove to be more than capable of overpowering even the negative 100 per cent returns of the losing ones, earning an overall positive return on the entire portfolio in the long run.

Imagine you have selected 10 stocks for your portfolio through your own rigorous due diligence and research and held on to it patiently for a long period, say the next 40 years.

Now, let’s say five of the 10 stocks in your portfolio performed exceptionally well, generating 15-30 per cent returns, while the other half of the portfolio eroded shareholder wealth completely.

This means that compounding returns of the right stocks more than makes up for the losses of the other ones and if held for a long time progressively, significantly grows the investor’s capital over time.

So the problem with investors that book early profits is that even if they find a winner, they are not willing to provide it enough time to reach its full potential. Instead, as soon as the rising price shows the slightest downtrend, investors exit the stock due to loss aversion.

They are unable to think rationally. Instead, they are driven by the need to appear to be a success and can’t risk being seen as a failure. Obviously, if profits are booked too early, then the investors lose out on opportunities.

In the short run, investors may feel like they have earned money. However, in the long run, they would have lost out on significant opportunities. Smart investors try to control their innate loss aversion tendencies and hold on to a stock if it has the potential to be a winner.

• Holding on to losing stocks:

Loss aversion causes investors to do the exact opposite of what they should be doing when faced with a losing stock. Let’s assume that an investor buys a stock, and it goes down in value because its fundamentals have deteriorated.

What are fundamentals of a stock?
A stock's fundamentals are the factors that are thought to contribute to the underlying company's value or worth as a business.

Fundamentals can include measurable, quantitative and qualitative data, and situational factors. They are key metrics for a company, such as cash flow and return on assets (ROA).

Loss aversion fallacy will cause the investors to hold on to the stocks despite there being no future for them. Selling the stocks at a loss would be seen as a personal loss to the investors. Hence, they do not sell the stocks because they feel that sooner or later, the prices will recover.

However, because of this fallacy, investors often forget that there is a time period involved in the calculation as well.

For instance, if an investor buys a stock for Dh100 and sells it for Dh101 after two years, he or she has earned just 0.5 per cent return on an annual basis. However, since loss causes them immense pain, they are willing to do so.

A good rule of thumb for investors is to check their portfolio. If their portfolio has a couple of winners followed by numerous losers, they are probably affected by loss aversion. In most situations, people keep churning the winners while irrationally holding on to the losers.

Investing in stock markets?
Loss aversion often causes investors to take a lot of unnecessary risks.

• Taking excessive risks

Loss aversion often causes investors to take a lot of unnecessary risks. For example, if investors face a loss, instead of accepting the loss, they often try to gain from it. A common strategy is called averaging out the prices.

‘Loss aversion’ vs ‘risk aversion’: What’s the difference?
In the field of behavioural decision-making, ‘loss aversion’ is a behavioural phenomenon in which individuals show a higher sensitivity to potential losses than to gains. Conversely, ‘risk averse’ individuals have an enhanced sensitivity/aversion to options with uncertain consequences.

This means if you have 100 shares of a company at Dh10 a share and the price slips to Dh8, investors tend to buy 200 shares. This is done so that the average cost of the share is reduced. In this case, the investor would now have 300 shares at Dh260, i.e., at Dh8.66 per share.

The idea is that now if the share moves to Dh9 per share, they would recover the losses of the earlier lot purchased at Dh10 as well. This is a fallacy because buying or not buying at Dh8 should not depend on the earlier decision.

This sort of investor behaviour is often a money gambling strategy wherein he or she tends to double bets to recover previous losses. The problem with this strategy is obvious. If the prices don’t move up and actually move further down, then the losses get multiplied!

What can investors do to avoid making emotion-based decisions on the stock market?

If you have a financial advisor, talk to them before you make any rash decisions, but always remind yourself to take a breather before every market-related buying or selling decision, veteran investors reiterate.

If you have a well-diversified portfolio, you can benefit from investing in the market. If you act on your concern about loss, you're giving up all potential of investment-related profit growth during the recovery phase.

Wealth managers often remind investors to have a plan for your investment before you purchase it, so when the market starts to look shaky, you know how to react. So think ahead about when you will sell your stock, whether it's doing well or not.

Think about what kind of news or circumstance could your respective stock’s company find itself in that would make you take your money out. That will help you calm your nerves because you have a plan if it were to happen.

Experts recommend a 3-A's approach for investors: Awareness, Analysis and Action
In order to avoid making emotion-based decisions, first be aware that emotions can lead to poor decisions. Second, analyse how prone you are to particular decision-making biases, and third, come up with steps to de-bias yourself, so you don't act on them without careful thought.

To simplify, don't act in the heat of the moment and take some time to actively seek information that goes against what you want to do.

Planners often tip investors to start investing sooner rather than later to take advantage of compound interest. While it's scary to be the first person in your family to invest in the stock market, to build generational wealth, someone has to be the first.

Wealth planners add that investors should also understand that loss aversion is just one factor that influences their decision-making.

Also, no behavioural trait is 100 per cent good or bad; they all tend to have both good and bad sides, which we can use to our advantage. Gaining a good understanding of one's behavioural tendencies can help us become significantly better at investing.

Bottom line

Most importantly, loss aversion causes people to panic and try to cut their losses when the market goes down sharply. This is the exact opposite of what should be done because experienced investors often buy when the market is going down, betting on a sooner-or-later price rebound.

Among other downsides, there one that’s unavoidable. Like mentioned earlier, if investors are too conservative with their investments, they could risk running out of money.

That's a big risk, market experts opine, because they think they're being safe, but in reality, they could be cutting themselves short for their financial future. Many times, people panic and make emotion-based decisions because they don't have a plan.

Investors often avoid any kind of investing in equity markets and stay completely risk averse. Instead, they keep most of their funds tied up in safe and conservative investments like fixed-income securities (like bonds). This, experts say, would be detrimental for young investors who may have a risk appetite.