Loss aversion is well documented in financial economics literature. Still it trips up both educated and ignorant investors in the same magnitude. Because it is based on human behaviour. It drives people to simply look away from losses. The impulse is too strong, people are prone to sell winning shares early and hold their loss-making ones. This is just exactly the opposite of what you should do as a prudent investor. If you are not aware of it, you will lose significantly even before you realise the same. So, investment scientists consider this as the greatest trap in investing. Let us understand what it is all about and how to avoid the same.

What is loss aversion?

Assume that you own shares that you have purchased for R100 apiece. After a few months, the stock falls by 20% and now it is trading at R80 per share owing to poor earnings reported by the company. The negative fundamentals certainly justify selling the stock right now, but generally you do not like to sell until the stock rises to at least R100 so that you can break even on the position. This scenario is known as ‘loss aversion’ and is one of the most common traps for investors. Instead of avoiding losses and investing in new opportunities, investors tend to hold on to losses and refuse to acknowledge them. This is because stocks acquire more psychological value when you own them, while unrealised losses are somehow considered less real. How to avoid such mistakes which we do unknowingly, here goes few techniques which will help you.

Losses alone are not good reason to sell

It is definitely tempting to solve the loss-aversion problem by simply selling the shares that you are holding on to which are doing poorly. In fact, one can use stop-loss orders in order to automate this process and take the emotion out of investing. The problem is that losses alone are not a good reason to sell. Investors should only sell when technical or fundamental factors dictate so. For instance, let us suppose that a company reports a drop in sales and the share price falls sharply lower. If you closely examine the annual report which reveals that management has been shutting down underperforming sales and adjusted its earnings before interest taxes depreciation and amortization, which has actually risen substantially. In this case, the market has simply failed to understand the annual report and the investor may be justified holding or even adding to the position.

As the question would you buy it again?

A good rule for knowing when to sell a position is to ask yourself: Would you buy the same share right now at the current price, if you do not already own it? Investors who would objectively still be willing to buy the share should consider holding onto it while those that would not entertain the idea may want to consider cutting their losses and selling the stock. Consider the same example that we have discussed above, if the annual reports showed the signs that management’s strategy was not working and sales were on the decline, investors would likely not be interested in buying the shares. Existing owners of the share may therefore want to consider selling the stock in order to cut their losses given that a near-term recovery is unlikely.

Use position sizing

Risk management tools and techniques can mitigate the effects of loss aversion by making the losses as less significant. In particular, investors should maintain position sizes that optimise diversification with no more than 5% of a portfolio’s total assets invested in any individual stock. It’s much easier to take a 5% loss than a 50% loss at a portfolio level. For example, suppose you as an investor held a portfolio of 10 stocks over a 10-year period. Over that holding period, one of the companies has grown disproportionately large, accounting for nearly 30% of the total portfolio value. If this stock were to drop in value, the investor may have a hard time selling and taking the loss relative to a share that accounted for less.

To conclude, avoiding losses is impossible. Even the best investors have stories to tell about their own losses. But to learn how to limit the losses avoid the loss aversion trap.

The writer is associate professor & accounting, IIM Shillong