Loss Aversion

It is true. Without realising it myself, I am no better than the normal irrational investor. Not that I believe I'm smarter than most people. I know I am very much the average Joe.

I was casually browsing through the book "The Warren Buffett Portfolio: Mastering the Power of the Focus Investment Strategy" when I came upon the chapter of The Psychology of Investing. In it, Loss Aversion was mentioned. I hereby reproduce it below:

According to behaviorists, the pain of a loss is far greater than the enjoyment of a gain. Many experiments, by Thaler and others, have demonstrated that people need twice as much positive to overcome a negative. On a 50/50 bet, with precisely even odds, most people will not risk anything unless the potential gain is twice as high as the potential loss.

This is known as asymmetric loss aversion: the downside has a greater impact than the upside, and it is a fundamental bit of human psychology. Applied to the stock market, it means that investors feel twice as bad about losing money as they feel good about picking a winner. This line of reasoning can be found in macroeconomic theory, which points out that during boom times, consumers typically increase their purchases by an extra three-and-a-half cents for every dollar of wealth creation. But during economic slides, consumers will actually reduce their spending by almost twice that amount (six cents) for every dollar lost in the market.

The impact of loss aversion on investment decisions is obvious and profound. We all want to believe we made good decisions. To preserve our good opinion of ourselves, we hold onto bad choices far too long, in the vague hope that things will turn around. By not selling our losers, we never have to confront our failures.

This aversion to loss makes investors unduly conservative. Participants in 401(k) plans, whose time horizon is decades, still keep as much as 30 to 40 percent of their money invested in the bond market. Why? Only a deeply felt aversion to loss would make anyone allocate funds so conservatively. But loss aversion can affect you in a more immediate way, by making you irrationally hold onto losing stocks. No one wants to admit making a mistake. But if you don't sell a mistake, you are potentially giving up a gain that you could earn by reinvesting smartly.

I cannot agree more. I am holding to some stocks which will not see significant capital appreciation in the short term. However, I am unwilling to cut my losses and invest in other stocks which are garnering more attention from investors (such as in the property and construction sector). So in short, I am not selling my mistake, hence forgoing my chance of a better return on other stocks.

I keep giving reasons (excuses...) to myself that this stock has a large float, is defensive, and gives dividends (even though it's just about S$0.005 per share before taxes and I only got it once since it was listed in May 2006).

Which brings me to another point. I used to like stocks that give dividends. But now, I think I'll sell the stock at a price where the dividend is factored in. It just isn't worth it to wait for the dividends. The government takes away 20% of it in taxes and it didn't even undertake any risks! At least capital gains from stocks are not taxed here in Singapore (as far as I know).

For the 2 years I've been in the stock market as a novice, my profit/loss statement doesn't record any loss, precisely because I hold onto the stock until it rises above my buying price before selling off!

I am a very conservative investor. My principle is capital preservation. No money, and worse, no guts to do contra trading or sell short. Probably that's why I still haven't managed to be as profitable as other people. But I shall use this to my fullest advantage. I'm sure there's an investment strategy that suits me and lets me earn comfortable amounts of money while I'm at it.