Loss Aversion

Loss aversion in behavioural 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.

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

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.

Nobody likes to lose, especially when it could result in losing money. The fear of realizing a loss can cripple an investor, prompting them to hold onto a losing investment long after it should have been sold or to offload winning stocks too soon—a cognitive bias known as the disposition effect. Rookies often make the mistake of hoping a stock will bounce back, against all evidence to the contrary, because losses lead to more extreme emotional responses than gains.

Behavioural economists claim that humans are wired for loss aversion, one of many cognitive biases identified by. Some psychological studies suggest that the pain of losing is psychologically about twice as powerful as the joy we experience when winning. However, several studies also call into question the practical effect or even the existence of loss aversion. Nonetheless, it may be possible that overwhelming fear can cause investors to behave irrationally and make poor investment decisions.

Loss psychology may even be the cause of the asymmetric volatility phenomenon exhibited in stock markets, where equity market volatility is higher in declining markets than in rising ones. According to prospect theory, people strongly prefer avoiding losses than they do acquiring gains.

This loss aversion is so strong that it can lead to negativity bias. In such cases, investors put more weight on bad news than on good news, causing them to miss out on bull markets—for fear that they will reverse course—and panic when markets sell-off.

One way of avoiding psychological traps is to follow a strategic asset allocation strategy. Rather than trying to perfectly time market sentiment, and abide by the old adage of letting your winners run, investors are advised to rebalance portfolios periodically, according to a rules-based methodology.

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