Loss Aversion

Loss aversion may be the most common investment bias of all, particularly among newer investors (though even highly experienced investors can fall foul of this bias). Loss aversion arises as a result of the human tendency to feel the pain of a loss more acutely than the pleasure of an equivalent gain. In practice, this results in investors refusing to sell out of investments that have fallen in value, even if the fundamentals have changed, in the hope that, somehow, the investment will return to its original purchase price and they can sell out at breakeven. Another effect of loss aversion is that, as soon as an investment makes a small gain (say 10%), the investor will sell out to capture this small gain and, thereby, avoid the pain of a potential loss. In a nutshell, then, loss aversion can cause investors to run their losers and cut their winners, a terrible strategy for long-term wealth accumulation.

Potential solution: If an investor struggles with loss aversion, they should define a maximum loss they are prepared to take on the investment and either resolve to sell the investment if it falls to the price representing their maximum loss level or, better still, set a stop loss at this price level to take all the emotion out of the selling decision. Another way to deal with loss aversion is to look critically at investments that have fallen in value and ask yourself “are the reasons for my original investment still valid and if I didn’t already own this investment, would I still be happy to buy it today?”.

It is important to note that not all investors will be susceptible to exactly the same biases. We are all perfect (and imperfect) in our own special way! You are the best judge to identify which biases have the better of you. Recognize these biases when you are exhibiting them and deliberately make an attempt so they do not cloud your investment judgment.

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