The Frontal Cortex

Loss Aversion and the Stock Market

Over the next few days, lots of people are going to be poring over their investment portfolio, trying to figure out which stocks to keep and which stocks to sell. Unfortunately, many of these investors will make the exact same mistake, causing them to lose vast sums of money over the long term.

The problem is loss aversion. Kahnemanandtversky stumbled upon loss aversion after giving their students a simple survey, which asked whether or not they would accept a variety of different bets. The psychologists noticed that, when people were offered a gamble on the toss of a coin in which they might lose $20, they demanded an average payoff of at least $40 if they won. The pain of a loss was approximately twice as potent as the pleasure generated by a gain. Furthermore, our decisions seemed to be determined by these feelings. As Kahneman and Tversky put it, “In human decision making, losses loom larger than gains.”

Loss aversion also explains one of the most common investing mistakes: investors evaluating their stock portfolio are most likely to sell stocks that have increased in value or, during a week like this, have gone down the least amount. Why? Because it hurts to take a loss. Unfortunately, this means that people end up holding on to their depreciating stocks. Over the long term, this strategy is exceedingly foolish, since it ultimately leads to a portfolio composed entirely of shares that are losing money. (A study by Terrance Odean, an economist at UC-Berkeley, found that the stocks investors sold outperformed the stocks they didn’t sell by 3.4 percent). Even professional money managers are vulnerable to this bias, and tend to hold losing stocks twice as long as winning stocks. Because selling shares that have decreased in value makes the loss tangible – and losing sucks – we try to postpone the pain for as long as possible. The end result is more losses.

Comments

  1. #1 EricJuve
    September 30, 2008

    The way to ensure that you lose is to sell stock. That action locks in the loss. This is IMHO a good time to buy, but check the fundamentals first. BTW I am not giving investment advice.

  2. #2 ngong
    September 30, 2008

    You don’t have cash on hand, yet you’re considering new purchases. How do you get the cash? A) Sell 5 stocks that have taken a beating and now trade cheaply. B) Sell one stock that has performed nicely. Point is: there may be some practical reasons for dumping the winners.

  3. #3 Renee
    October 1, 2008

    Interesting that a study on the pyschology of gambling is segued into a discussion about investing in the stock market.

    I believe the average American 401K investor is has been assured over and over, with charts and whatnot, at nearly every annual Human Resource Annual Benefits Meeting,at nearly every company in this country, that it is a LOSS to just leave their money in a savings account.

    No, no. A Money Market Account, safe, secure (not FDIC insured, but let’s just hurry through that and focus on the charts again) may have its ‘ups and downs’ but over time; well, again. We have all been assured it is surely more profitable than those ‘old fashioned’ pensions our grandfathers and fathers relied on.

    The jump to a Vegas mentality about betting? Not relevant to the average American.

  4. #4 Rachael
    October 23, 2008

    >> Unfortunately, this means that people end up holding on to their depreciating stocks. Over the long term, this strategy is exceedingly foolish, since it ultimately leads to a portfolio composed entirely of shares that are losing money.

    I’m not sure if this strategy applies to all of us.

    The more scared that Americans are of a recession, the more likely it is to worsen. And the more that long-term investors try to act like day traders (who don’t do so well anyway) by betting on the market, the less well off we will be. The current state of the market is as unpredictable as it ever has been.

    For those of us who are young with 401k’s, isn’t a better strategy to trust in the overall upward motion of the market (say 20 years from now) and not contribute to the increasing stampede of stock-dumping? Sure I could try to dump poorly performing stocks now, hope the market drops further, attempt to buy them back at their lowest point, and then gather the profit from that small dip in price — but that seems quite a gamble. If we all take that gamble, most of us will lose.

  5. #5 Credit Repair
    February 22, 2011

    The pain of a loss was approximately twice as potent as the pleasure generated by a gain. Furthermore, our decisions seemed to be determined by these feelings.

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