Loss aversion? Most investors and traders are victim of this phenomenon!

Loss Aversion:

In economics and decision theory, loss aversion refers to people’s tendency to strongly prefer avoiding losses to acquiring gains. Some studies suggest that losses are twice as powerful, psychologically, as gains.

V Raghunathan explains this phenomenon in his book The Corruption Conundrum and Other Paradoxes and Dilemmas. ‘The pleasure of Sensex going up from 10,000 to 20,000 was much less than the pain of its drop from 20,000 to 10,000, wasn’t it? In short then, losses loom larger than profits,’” he writes.”

“ So there are two aspects to the whole thing. One, the inability to sell and cut losses, and two, to keep on buying more in the hope of averaging down the cost. This throwing of good money after bad is referred to as ‘sunk-cost’ fallacy.”

“In fact Tim Harford explains this rather well in his new book Adapt in which he talks about top level poker (a card game) players. “Poker players explained to me that there’s a particular moment at which players are extremely vulnerable to an emotional surge. It’s not when they’ve won a huge pot or when they’ve drawn a fantastic hand. It’s when they’ve just lost a lot of money through bad luck or bad strategy. The loss can nudge a player going ‘on tilt’ —making overly aggressive bets in an effort to win back what he strongly feels is still his money. The brain refuses to register that the money has gone. Acknowledging the loss and recalculating one’s strategy would be the right thing to do, but that is too painful,” writes Harford.”

There is another beautiful example in the book A Mathematician Plays the Stock Market written by John Allen Paulos. Paulos shares his experience of investing in a stock called WorldCom, which at a certain point of time was the second largest telecom company in the US. In 2002, it came to light that the company was essentially boosting its earnings by resorting to accounting fraud. The stock price had started to fall even before that, when investors realized that analysts following the sectors had been writing trumped up reports on the kind of earnings US telecom companies would make in the future. The sector had built up huge overcapacity over the years and did not have much pricing power.”

As he writes, ‘By late summer 2000, WorldCom had fallen to $30 per share, inciting me to buy more. By this I don’t mean that there wasn’t a rational basis for investing in WorldCom stock…If you didn’t look too closely at the problems of overcapacity and the long distance phone companies’ declining revenue streams, you could find reasons to keep buying…Of course, for every facile invitation I extended myself to ‘average down,’ I ignored an equally facile warning about not attempting to ‘catch a falling knife.’”

“And he kept buying more stock!”

“Yes. In fact as he points out, ‘I kept telling myself that I’d incurred only paper losses and had lost nothing real unless I sold. The stock would come back, and if I didn’t sell, I couldn’t lose.’”

Most investors hoping to minimize loss try to buy more and more of the same stock and lower price and become victim of this  Loss Aversion Phenomenon.

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