Why the emotion of loss aversion could kill your returns

Risk (or uncertainty) in equities is often measured by the degree of volatility. While this is a measure that may have some utility for portfolio management (specially if one has a need to exit positions in case of price drops), I have often felt risk in investing is best measured as the probability of permanent loss of capital. That is because, it is not risk or uncertainty that investors really fear, but losses (notional or permanent) as measured by decrease in capital value that they are afraid of. Any volatility in market prices that does not result in notional losses does not affect the investor (emotionally) precisely because of this tenet.

lossaversionThis is demonstrated aptly by the concept of ‘Loss Aversion’ in behavioral finance – the field of study that analyzes the impact of emotions on investing behavior. The key tenet is that human reactions to the probability of profits and losses are different. We become conservative when faced with profit chances, and take undue risks when faced with prospects of loss.

Consider this scenario – where you have Rs.10,000/- with you, and have to make one of the two choices: (a) Choose a guaranteed gain of Rs.5000/- OR (b) Choose to toss a coin – if its heads, you gain Rs.10,000/- and if its tails, you gain nothing. Which option will you choose?

Now Consider another scenario – where you have Rs.20,000/- with you, and have to make one of the two choices: (a) Choose a guaranteed loss of Rs.5000/- OR (b) Choose to toss a coin – if its heads, you lose Rs.10,000/-, and if its tails, you lose nothing. Which option will you choose?

It is likely for majority of people to choose option (a) in the first scenario, and option (b) in the second scenario. Why is it that in the first scenario, we are not willing to take a chance on more profit, even though we lose nothing, while in the second scenario, we are willing to take a chance to reduce loss, even though we may lose more? That is because, in the first scenario, we have guaranteed profit, so the pleasure we get out of more profit is high, but not as high as the pain we will suffer in case that profit goes away, and we are not fine with the prospect of remaining at status quo. Whereas in the second scenario, we are faced with sure losses, but we are willing to take the chance, even though those losses could actually double, because of the possibility of not having to lose anything. Again the pain of loss is so high, that we take higher risk, just to get back to status quo, even though we could possibly face even higher losses.

lossaversionProspect theory IIISo in case one is unable to keep emotion out of investing, and unable to handle market declines with a calm and rational mind, this is a key emotional or behavioral takeaway that one will do well to remember: we like profits, but we hate losses even more. So when faced with possible losses, we are prone to take higher risks to avoid the possible loss, but when faced with possible gains, we are prone to lock in our gains without taking risks.  Therefore, most investors will end up booking profits early and riding their losses rather than the other way round. Selling losers because the fundamentals have changed is one of the most emotionally painful things for individual investors to do. Well -if you genuinely believe in a company’s earning prospects and valuations and are able to keep your head, it is prudent to hold and even buy more during falls, but one must be aware that – that is the real reason for one’s actions, and not the loss aversion tenet at play.

So, in conclusion, are people risk averse or loss averse? It is not that people do not like risk or uncertainty so much, but it is pretty clear that they hate losses a lot, much more than they love profits. Awareness of this tenet will perhaps help investors to decide truthfully on the best way forward specially during price declines when the stomach is churning and the heart in fear, and use their head to take a rational rather than an emotional decision. As the popular Indian ad says, “Darr Ke Aage Jeet Hai.”

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