Psychology plays a major role in any decision making. There are ample studies to indicate that poor decision making can be attributed to a few key heuristics, leading to terrible consequences for the decision maker.
One such heuristic is called loss aversion. It was identified by two Israeli psychologists, Daniel Kahneman and Amos Tversky. In Decision Theory, loss aversion refers to people’s tendency to prefer avoiding losses over acquiring equivalent gains: it’s better to not lose Rs. 100 than to find Rs. 100. Studies conducted by above mentioned academicians suggest that psychologically, losses are twice as impactful as gains.
Some examples are as follows,
- We don’t want to throw away the stuff we don’t need
- We don’t sell a stock that is below our purchase price just because we don’t want to take a loss
- We don’t sell a house for less than what we paid
- If we lose the first bet in a casino, we often place a second bet to recover our money, and another and so on
- We buy a subpar cash back policy because we are averse to lose term insurance premiums in case we don’t die
These are a few day to day examples where our decision making is influenced by loss aversion heuristic. These decisions may be an outcome of our ego or ignorance.
We believe Investing is one of the most affected fields when it comes to loss aversion thinking. We get averse to taking losses even if newer facts/advices suggest we might be wrong. Even the greatest investors haven’t been able to escape losses. Peter Lynch once said, “You won’t improve results by pulling out the flowers and watering the weeds.”
We tend to average down our losers despite knowing that our initial decision itself was wrong. This goes back to our behaviour in the casino where we keep losing more money in the hopes of gaining some back. At the same time, we cash in our profits early in fear of losing the possible gains.
This very nature, we believe gives us sub-optimal returns, lost opportunities and sleepless nights Losing money on an investment is called ‘sunk cost’ and just as you don’t make additional holes in the keel of a sinking boat to save it, we should refrain from incurring more losses to recover earlier ones.
We would like to recommend the following so that you don’t fall victim to loss aversion
- Every investment made should be seen as fresh investment decision everyday you watch it. Losses or gains should be hidden from vision while making this decision. Say you made an investment in J.P. Associates or some thematic MF in the past thinking it was a great stock/fund. Turn a blind eye towards loss or gain incurred and re-think will you commit the same amount today? If the answer is NO, then don’t feel bad selling those investments
- Imagine someone sold your loss making stock/fund while you were asleep. Will you go and buy it back as soon as you wake up? If answer is NO, sell that stock/fund assuming your friend accidently did it for you
- Take your loss at once, it will hurt the least. People often ask us whether they can sell the stock/fund in parts as there might a chance to recover some of the loss. Taking a loss is no doubt very painful. So why would you want to feel the pain multiple times, just doing it all at once makes it less painful.
- Loss can be recovered by investing in other better opportunities. If you lose money on J.P. Associates, rather than recovering money back from the same stock, isn’t it logical to recover it back by investing in HDFC Bank or in higher conviction stock?
- Try and look at the big picture and assess net impact on overall net worth rather than worrying about the losses incurred on an individual stock. A stock may have lost 50% or carries a large absolute loss but minuscule as a percentage of net-worth. Say Rs. 2.5 Lac is lost on invested capital of Rs. 5 Lac but on your overall net-worth of Rs. 5 Cr it is just 0.5% which doesn’t sound so terrible
We hope that these suggestions will help you overcome your loss aversion. As humans, we often make subconscious decisions. With this checklist you can take a pause and reassess your decision thereby leading to better decision making.
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