Slide 1

What is loss aversion bias?

Loss aversion is the tendency to avoid losses over achieving

equivalent gains. Broadly speaking, people feel pain from losses
much more acutely than they feel pleasure from the gains of the same
size. Loss aversion bias typically shows up in financial decisions:
people often need an extra—and sometimes significant—incentive to
take financial risks that might result in a loss.
Loss aversion in behavioral economics refers to a phenomenon where a real or potential
loss is perceived by individuals as psychologically or emotionally more severe than
an equivalent gain. For instance, the pain of losing $100 is often far greater than the joy
gained in finding the same amount.

Loss aversion was first identified by Amos Tversky and Daniel Kahneman. Loss aversion
implies that one who loses $100 will lose more satisfaction than the same person will gain
satisfaction from a $100 windfall.

The psychological effects of experiencing a loss or even facing the possibility of a loss might
even induce risk-taking behavior that could make realized losses even more likely or more
severe.

Slide 2

Why does it matter?

Loss aversion can result in clients avoiding risk, leading to overly

conservative portfolios that do not deliver the returns they need to
achieve their goals. It can also push clients to sell during a stock
market downturn simply to avoid further losses—which could mean
they miss out on gains when the stocks they have sold rebound.

 Loss aversion is the observation that human beings experience

losses asymmetrically more severely than equivalent gains.
 This overwhelming fear of loss can cause investors to behave
irrationally and make bad decisions, such as holding onto a stock for
too long or too little time.
 Investors can avoid psychological traps by adopting a strategic
asset allocation strategy, thinking rationally, and not letting emotion
get the better of them.
Slide 3
Selling Winners and Holding Losers

Many investors don’t acknowledge a loss as being such until it is realized. Therefore, to avoid
experiencing the pain of a “real” loss, they will continue to hold onto an investment even as their
losses from it increase. This is because they can avoid psychologically or emotionally facing the fact
of their loss as long as they haven’t yet closed out the trade. In their subconscious, if not their
conscious, thinking, the loss doesn’t “count” until the investment is closed. The negative effect of
this, of course, is that investors often continue to hold onto losing investments much longer than
they should and end up suffering much bigger losses than necessary. That’s what loss aversion looks
like in practice.

Well, how do you guard against the loss aversion bias? One practical step is to always use firm stop-
loss orders to minimize your potential loss in any trade. That kind of pre-commitment to always
limiting your risk helps to mitigate the tendency to fall into a loss aversion trap.

Slide 4
How Loss Aversion Affects
Investment Decisions
Behavioral 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., we will have a closer
look at how it impacts the psychology of the people investing in the stock market.

What is Loss Aversion?

There is a famous saying in Wall Street. The saying goes like this, “There are two rules in financial
markets.”

Rule #1: Don’t lose money

Rule #2: Don’t forget rule #1

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
$500 as compared to the pain they would get while losing $500. 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.
Some of these irrational decisions have been listed below:

Early Profit Booking: A lot of investors are fixated on finding winners. 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. This often means 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 Losers: 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. 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
$100 and sells it for $101 after two years, he/she has earned just 0.5% 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.

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. This means that if you have 100 shares of a
company at $10 a share and the price slips to $8, 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
$260, i.e., at $8.66 per share. The idea is that now if the share moves to $9 per share, they would
recover the losses of the earlier lot purchased at $10 as well. This is a fallacy because buying or not
buying at $8 should not depend on the earlier decision. This sort of behaviour is often seen in casinos
wherein gamblers tend to double their bets to recover their 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!

Avoiding Equity Stocks: In some cases, investors have burnt their hands so badly that they avoid
any kind of investing in equity markets. Instead, they keep most of their funds tied up in fixed income
securities. This is detrimental for young investors who may have a risk appetite.

Sell Offs: 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. Smart investors are the
ones who are buying when the market is going down.

The bottom line is that investors must be aware of the psychological fallacy of loss aversion.
Awareness will help them manage the emotions and therefore earn superior returns.

 Slide 5

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:

Invest in insurance products that have a guaranteed rate of return

Invest in government bonds

Purchase investments with relatively low price volatility

Consciously remain aware of loss aversion as a potential weakness in your investing 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.)

Slide 6

Is loss aversion the same as risk aversion?

Risk aversion is the general bias toward safety and the potential for loss.
Loss aversion is a pattern of behavior where investors are both risk
averse and risk seeking.

 Risk Aversion is the general bias toward safety (certainty vs. uncertainty) and the
potential for loss. When faced with a choice of two investments with the same
expected return, a risk averse investor will chose the one with lower risk. 
 Loss Aversion is a pattern of behavior where investors are both risk averse and risk
seeking. In simple terms, how often does a client sell a winning stock to capture
gains while holding on to a losing position in the hope of not having to realize that
loss? A common market mantra is that a one dollar loss in a position is twice as
painful as a one dollar gain is pleasurable, and they cause different reactions. 

The behavioral influences here, from pride to fear, impact the overall decision-
making process, and a SmartRisk analysis can help manage those behaviors by
setting, upfront, some reasonable risk parameters.   

Slide 7
How you can let go of loss aversion

1. 1.Look at your holdings – from investments to real estate to inborn items – with
fresh eyes. If you were starting from scratch, which would you still want to have?
Which could you part with?

2. 2.Give careful thought to what your true long-term risk tolerance is, and stress test
your portfolio. This can give you the confidence to stick to the plan even when
conditions or your circumstances get more volatile.

3. 3.Look past loss. Instead of dwelling, focus on how moving forward can help you
keep progressing toward your goals.
 4. 4.Look at long-term market data: While events like the financial recession and dot-
com bubble were extremely significant at the time, when seen in context of a longer
time span, they were temporary speedbumps in the consistent growth of the market.

5. 5.Look for help. Seek out the perspectives of people whose beliefs differ from your
own and professionals with specialized expertise. In the case of your financial future,
it helps to work with an objective third party – like an experienced financial advisor –
who can offer perspective in addition to wealth planning and investment support.

Slide 8
Why is loss aversion important?
. Loss aversion is a natural human tendency that exists to keep us from incurring
losses. Though being risk-averse is useful in many situations, it can prevent logical
choices. Loss aversion can prevent people from making the best decisions for
themselves to avoid failure or risk; it’s essential to avoid loss aversion when making
decisions with potential gains.

How to avoid it
it’s essential to know how to avoid loss aversion and its influence on decisions,
especially when making decisions with potential gains.

Framing

The way a transaction is framed can significantly influence an individual’s

perception of loss aversion. Framing a question as either a loss or a gain can
change an individual’s response or decision. 12 When faced with a decision that
could be influenced by loss aversion, try framing the question differently to
highlight and potential gain of a transaction.

Putting Loss into Perspective

A simple way to tackle loss aversion is to ask ourselves what the worst outcome
would be if the course action was taken. Usually, this helps individuals put loss,
and the strong associated feelings of loss into perspective and better rationalize if
it’s worth making a decision or not.

Risk Aversion vs. Loss Aversion