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Why losses can lead to more losses - Views on News from Equitymaster
 
 
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  • May 11, 2009

    Why losses can lead to more losses

    In the previous article on 'social proof', we discussed how analysts and investors pay undue attention to what others are thinking. In this article, we shall examine another tendency called 'loss aversion'.

    What is 'loss aversion'?
    Losses have a much larger impact on us than corresponding gains. Given a 50:50 chance between earning Re 1 and avoiding a loss of Re 1, people chose the 2nd option. Since the two options are mathematically equivalent, people should be indifferent between them, i.e. have no preference for either. But in reality, people have a marked tendency to avoid losses. This tendency is called 'loss aversion'. In fact, according to some studies it takes a gain or Rs 2 to offset a loss of Rs 1.

    The reason behind this tendency is easy to understand. Human evolution happened predominantly in conditions of scarcity. In their search for the basic necessities of life, the early humans constantly had to make the tradeoff between what they already had and what they could hunt or gather by taking a risk. Given that their environments posed substantial dangers, they developed a preference for protecting what they already had.

    This irrationality plays a big role in a variety of decisions, including investing in stocks.

    Examples

    • Territorial integrity: Nation states have time and again gone to war due to 'loss aversion'. Historically, it has been incredibly hard for countries to cede even a small portion of their stand, territory etc. even if, all things considered, everyone might be better if they did.

    • Commitment: We find it extremely difficult to give up on a cause once we have committed a lot of time or energy to it, even if our time was better spent from that point forward on something else.

    • Hanging on to underperforming stocks: As Philip Fisher said "There is a complicating factor that makes the handling of investment mistakes more difficult... if we sell at a small loss we are quite unhappy about the whole matter. More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realised, the cost of self-indulgence becomes truly tremendous."

    Avoiding the loss aversion bias in stock picking

    • Admit: The first step in dealing with biases is to admit their presence.

    • Start afresh: One you realise that your stock pick was wrong, make sure that you don't fret about making good the loss somehow. As Warren Buffett says, "You don't have to make it the way you lost it." For all you know, your time, energy and money (even though depleted) could be better utilised elsewhere.

    • Constantly generate options: By constantly generating alternative investment choices, you can be alive to the best use of your capital at any given point of time, no matter what mistake you've made in the past. Moreover, you will be less desperate for the mistake to correct itself.

     

     

    Equitymaster requests your view! Post a comment on "Why losses can lead to more losses". Click here!

    1 Responses to "Why losses can lead to more losses"

    vijay barve

    May 11, 2009

    should we srictly put a stop loss of 10 15 percentile to protect from this dieases a most common mistake of good investor .please suggest some practical solutions dr vijay barve

    Like 
      
    Equitymaster requests your view! Post a comment on "Why losses can lead to more losses". Click here!
     

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