Loss Aversion Bias - Meaning, Examples, Causes & How to Avoid Loss Aversion Bias

Imagine a football match between Team X and Team Y. It’s the final on an international stage, and the stakes are high. As the match proceeds, it quickly becomes apparent that Team X is playing a very defensive game while Team Y is constantly attacking. Team X is so focused on not letting Team Y score a goal that it is not making much of an attempt to achieve a goal itself; the fear of loss has overtaken the prospect of a potential goal should it play a more attacking game. It reaches a point where Team Y’s attacking prowess earns it a goal anyway, and now Team X cannot equalise the score because there’s no time. In this case, one could say that Team X suffers from loss aversion bias. This phenomenon is common in the world of investing when making investments in mutual funds. This article will seek to explain the concept of loss aversion bias when making and managing investments and how you can overcome it.

What is Loss Aversion Bias?

Loss Aversion Bias is a behavioral trait in investing where an actual or potential loss psychologically affects individuals or investors much more severely than an equivalent gain. For instance, if you lose Rs 2,000 in a day but at the same time also make an unexpected gain of Rs 3,000, it is the loss that tends to have a more substantial impact. Loss aversion, however, is different from risk aversion. Risk-averse investors prefer playing it safe and wish to reduce the possibility of loss as much as possible, which is accordingly reflected in their portfolio by choice of their investments. Investors afflicted with loss aversion bias do not necessarily make risk-averse decisions; on the contrary, they could invest in risky assets. But they can’t handle uncertainties, and that is when the loss aversion bias manifests itself.

What causes Loss Aversion Bias?

Losing money is often hard to accept. And psychologically speaking, people are likely to remember the pain of a loss more vividly than the joy of a profit. But smart, seasoned, or experienced investors know that losses cannot be entirely avoided; they are part and parcel of the field of investing. Thus, when a loss occurs, they think rationally and book losses to shift the money to better-yielding assets. In sharp contrast, when a person suffers from loss aversion bias, his fear is so great that he is likely to keep holding on to a losing investment even when rational factors suggest otherwise. His decision-making tends to be more emotional, and he holds on to those loss-making investments hoping they could rebound. Till a point occurs when he is ultimately forced to sell his investments at a considerably higher loss than would have been the case had he liquidated his investments earlier. Investors with loss aversion bias tend to make relatively poor investment decisions. They sell a bad investment too late and a good investment too soon. Their decisions are influenced by emotions rather than a rational, disciplined approach.

Also Read: What is Hindsight Bias?

Loss Aversion Bias Example

Here’s an example to illustrate the concept of loss aversion bias. Consider Ramesh, a rookie investor who has invested in Company A. Ramesh had researched the company; it seemed to have a solid core business, and its growth prospects looked promising. But then the management took a business decision that did not align with its vision; it diversified into a vertical entirely unrelated to its primary business. The company’s price began falling. If Ramesh had been a smart investor, he would have exited this investment and booked losses because the primary rationale for investing in the company was no longer valid. But the idea of suffering a loss was too much for Ramesh to bear. Two mutual fund schemes – A and B. Scheme A is a sectoral fund investing in technology stocks. Scheme B is a large-cap fund investing across sectors. After a year of volatility in the stock markets, where technology stocks were hardest hit, Ramesh decides to look at his investments in both schemes. He notices that Scheme A is showing a loss of Rs 10,000, while Scheme B has weathered the storm reporting gains of Rs 12,000. Ramesh, however, is deeply unhappy. Afflicted by loss aversion bias, he continued to hold on to his investment in the misguided hope that the price might bounce back. But that scenario did not unfold, and Ramesh ended up staring at a loss bigger than it would have had he not let emotions affect his decision-making. The loss of Rs 10,000 hits him harder, while the gains that Scheme B has generated for him go unnoticed.

How to Overcome Loss Aversion Bias?

Here are some steps to overcome loss aversion bias:

• Follow a disciplined asset allocation strategy. Thus, even if one of the assets is underperforming, the potential losses can be minimised or offset by other assets in the portfolio. Re-balance your portfolio periodically.

• Ideally, have a process in place while making your investments. And let this process along with In addition to this, rational thinking that is devoid of emotions can guide you in how to build your portfolio.

• Learn to accept that despite your best intentions, losses can occur due to factors beyond your control. It is best to take them in your stride or book losses when the mutual fund’s objectives no longer align with your own, move on and park that money in an investment avenue that can generate better returns. The overall goal of investing is not to make gains every time; rather the objective must be to plan your portfolio in such a way that gains outweigh your losses and in the process, you still achieve your financial goals.

To conclude…

It is fair to say that nobody likes to lose money. The real test is to avoid getting attached to your investments and not get swayed by emotions. If an investment is racking up losses and a rational analysis tells you that the chances of recovery look pretty slim, it makes sense to book your losses and move forward. While investing in any asset class, including investment in mutual funds, losses can’t always be avoided, but you can minimise the quantum of failure if you overcome loss aversion bias.

Additional Read: What is Information Bias?