Being averse to losses is not necessarily always bad, but too much of it can skew your financial planning.
Most of us feel twice the pain when we make a loss on an investment than when we make a gain. This phenomenon is referred to as the loss aversion bias. Simply put, the loss aversion bias is a behavioural pattern where instead of cutting our losses, we are reluctant to sell an investment when it is making great losses. The flip side of the loss aversion coin is we are eager to sell investments that are doing extremely well, to book profits.
The reluctance to sell a losing stock could stem from our inability to accept that we have made a wrong call. In our quest to make up for the wrong call, we insist on recovering our initial investment. It is our attitude towards losses that needs to be examined. If we wait too long to exit a losing investment or spend more money to recover lost money, then we definitely are experiencing the loss aversion bias. This behaviour adversely affects all our investments.
Before we correct this destructive pattern, how do we determine that we actually have a loss aversion bias? The following indicators might help you understand your approach to losses and gains. You might have a loss aversion bias if you.
# Do not sell a dud stock or mutual fund unit for a loss
# Find it easier to sell a winning investment than a losing investment
# Prefer to invest in fixed deposits over stocks and equity mutual funds
# Make investment decisions based on how much you have invested in it or spent on it already
# Are comfortable booking a gain, instead of taking on a slight risk to gain more, but are uncomfortable booking a loss, exposing yourself to a higher risk of losing more
Loss aversion should not be mistaken for risk aversion. A risk-averse investor is hesitant to invest in potentially risky investments. An investor exhibiting the loss aversion bias may be agreeable to invest in risky investments but is hesitant to book a loss or hold on to a win. Ask yourself these additional questions related to your current investment habits.
# How often have you sold or been tempted to sell the gainers to lock in the profit?
# How often have you held on to dud investments to recover the principal?
If this is your approach to your investments, then you are of the belief that given time, your losing investments will outperform your winning investments, simply because the winners are profiting and the losers are losing. This logic in itself is extremely flawed.
Being averse to losses is not necessarily always bad. But too much of it can skew your financial planning. It is imperative to manage investment risks, and one of the key components of managing risk is to understand what a loss means. A loss is not limited to a loss of principal. You need to take into account the opportunity loss and the loss of purchasing power as well.
What can you do to ensure that your investment decisions aren’t operating from a loss aversion pattern?
# Wipe your slate clean and start anew. If you have made a bad call, admit it, accept it and move on to making better investment decisions.
# Ask yourself if you would invest in the same stock or mutual fund today?
As the price will be lower (if it is a dud investment), and your answer is no, then you should sell your holdings. For a stock or fund making a profit, if your answer is yes, then hold on to the investment instead of booking a gain.
Loss aversion is an emotional take on your investments. There is no place for emotions in the equity market. Consult with a financial advisor, who will not only help in planning your finances but will also keep in mind your investment behaviour and will advise you in navigating through your investment decisions. Remember to take into account your future economic interest instead of your temporary emotional pain, and in the long term, you will be happier for it.
(By Amar Pandit, CFA and Founder, Happyness Factory)