Loss aversion is a tendency in behavioral finance where investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains. The more one experiences losses, the more likely they are to become prone to loss aversion.
For instance, say you bought 100 shares of Yes Bank at Rs 50 per share. If the stock fell to Rs 30, and you bought another 100 shares, your average price per share would be Rs 40. If the stock further fell to Rs 15, and you bought another 100 shares, your average price per share would be Rs 30. And if you now feel the need to sell, you would be facing a loss of approx 53%. (We have taken this only for an example purpose, no recommendation or fundamental is done for the stock)
Purchasing more shares to average down the price wouldn't change that fact, so do not misinterpret averaging down as a means to magically decrease your loss. This is a very common practice followed by investors where they keep buying more shares at the dip, thinking they are lowering their cost, without understanding that they are just incurring more losses. Such methods of buying at a lower cost must be followed only and only where the company has strong fundamentals and you are sure that the current dip in the price is due to some change in the market scenario. If the losses continue, then do you think buying more is the solution or booking your losses is?
Research on loss aversion shows that investors feel the pain of a loss more than twice as strong as they feel the enjoyment of making a profit.
EXAMPLES OF LOSS AVERSION
Below is a list of loss aversion examples that investors often fall into:
- Investing in low-return, guaranteed investments over more promising investments that carry a higher risk
- Not selling a stock that you hold when your current rational analysis of the stock clearly indicates that it should be abandoned as an investment
- Selling a stock that has gone up slightly in price just to realize a gain of any amount, when your analysis indicates that the stock should be held longer for a much larger profit
- Telling oneself that an investment is not a loss until it’s realized (i.e., when the investment is sold)
HARMFUL EFFECTS OF LOSS AVERSION
- Loss aversion causes investors to hold on to loss-making stocks or funds for a very long period. They refuse to sell a stock or fund at a loss and can hold on to it for long periods of time even if there are better alternative investment options available.
- Aversion for losses makes investors hold on to loss-making stocks or funds till the loss is recovered. Ultimately, when the investor sells the stock or fund, a long time may have elapsed and the return on the investment is very low.
- There are also instances of investors holding on to loss-making stocks/funds and then finally selling them at a much bigger loss than what they would have incurred if they sold earlier.
- Loss aversion is commonly seen in property / real estate investments. Investors refuse to sell their property at a loss and hold on to it hoping the investment will turn profitable someday. Throughout the holding period of the investment, they pay interest on their loans which could have been avoided if they sold earlier.
RATIONAL STRATEGIES FOR AVOIDING LOSSES
Let’s look at some examples of how a company or an individual can reasonably minimize risk exposure and losses:
- Hedge an existing investment by making a second investment that’s inversely correlated to the first investment
- Invest in endowment plans/debt products that have a guaranteed rate of return so you have your safety net in place
- Invest in government bonds directly or via mutual funds (but be aware of the liquidity and the interest rate risk over there)
- Purchase investments with relatively low price volatility and only after thorough research. Do not just buy because something is priced low. Understand the value of it before investing.
- Consciously remain aware of loss aversion as a potential weakness in your investing decisions and make more conscious smart decisions.
- Invest in companies that have an extremely strong balance sheet and cash flow generation. (In other words, perform due diligence and only make investments that rational analysis indicates have genuine potential to significantly increase in value.) and DO NOT MAKE INVESTMENTS BASED ON TRENDING TWEETS AND TELEGRAM GROUPS.
No one likes to make a loss, but loss aversion can cause you to lose more money or make less money than what you feared to lose. Sometimes, it is better to book a loss and move on to alternative investment options. This moving on will help you invest for the long term better and make money eventually.
It is difficult to separate emotions from investing, but successful investors are able to do it. You should do what is right to meet your financial goals including selling funds that are underperforming consistently and switching to better funds. A good financial advisor can help you overcome this behavioral bias. You should have a rational and objective portfolio performance evaluation process; take the help of a financial advisor if required. We are SEBI registered investment advisors and can help you make sound investment decisions - you can reach out to us at email@example.com, in order to help you make a financial plan for yourself.