When it comes to exploring the ways in which human emotions cause investing mistakes, a simple illustration can be a big help. With that in mind, here’s a question…
Let’s say you and I play a game based on the flip of a fair coin. If you call it correctly, you win £110. But if you lose, you pay me £100. Does that sound like an appealing proposition?
Research suggests that you’ll probably tell me where to go. In fact, when presented with this gamble most people demand a much, much higher potential payback. Tests have shown that the average player offered this type of challenge demands a win of around £200 to accept it (and often a lot more).
The reason for that comes down to human emotion. Typically, we feel the pain of a loss much more than the satisfaction of a win. So what’s needed is a gain-to-loss ratio of something like 2-to-1 for the average punter to feel comfortable with this game. In behavioural science this is the essence of something called loss aversion.
The pain of losing
On its own, loss aversion has been blamed for one of the reasons why investors sell winning positions too readily and hold losing positions too long. Put simply, crystallising a loss, and accepting failure, seems to be much harder than taking profits on a winner - even though it can damage returns.
But there’s more. Loss aversion can also trigger other decisions that don’t work well in investing. For a start, it can cause investors to sell positions at the wrong time, particularly when faced with uncertainty. It may lead us to become too risk-averse and forget that, as an asset class, stocks do endure short term volatility but still tend to outperform other assets over the long term.
This problem is made worse when you combine loss aversion with another well known emotional tendency of constantly watching portfolio performance. When that happens you get something called myopic loss aversion.
To start untangling what all this means - and why it’s important to be conscious of loss aversion - it’s worth taking a flick through the research...
A whistle-stop tour of loss aversion
Our introductory coin flip test has its roots in work dating back to the 1960s by Paul Samuelson. But loss aversion was really…