Saturday, May 21, 2011

Loss Aversion

Why you pick loss over gain

It was mid-2007 and mutual fund investments were giving fabulous returns. Enamored by a particular fund, an acquaintance invested nearly 50% of his SIP money in it. It seemed like a good decision as the fund gave returns as high as 150%. Like many others, he didn't think anything would go wrong. But then on 15-Sept,2008 the Lehman Brothers filed for bankruptcy, and stock markets across the world started to fall. When the NAVs of his star fund went into a free fall, performing worse than the others, the acquaintance conducted a desperate check on the various schemes he had invested in. He found the funds full of speculative stocks.

Despite this, he could not get himself to redeem the accumulated fund units and limit his losses. So the losses continued to pile and he continued to hope that he would recover these. He justified these as being paper losses, convincing himself that til he redeemed the units, the paper losses would bot become 'real' losses. In fact, he started buying more units to average down the cost of buying a single unit. A few months later, the fund manager quit the mutual fund and the value of his investment fell abysmally low. It was then he decided to get out of the fund. Why did he wait till the last minute to rid himself of the pilling losses? He has been a victim of 'loss aversion'.

What is loss aversion?
Loss aversion is the tendency to avoid a loss rather than make a gain. This concept is rooted in the Prospect theory, according to which people tend to base their decisions on perceived gains rather than perceived losses because the emotional impact of losses is far greater than that of gains. Extensive research in behavioural economics shows that people experience twice as much pain when they face a loss in comparison to the pleasure they feel with a gain. So the pleasure derived from a rising Sensex is not as deep as the pain one suffers when it drops sharply.
Another reason  people stick with losing propositions is that they find it difficult to admit they took a wrong decision. They keep hoping that they will recoup the losses, and in the process, they end up deepening these. "When you sell a loser, you don't just make a financial loss; you take a psychological loss from admitting you made a mistake. You are punishing yourself when you sell.", says Jason Zweig, a personal finance columnist at
Wall Street Journal, in his book, Your Money and Your Brain. "Once you make an investment, you can't help regarding it as yours. When you buy a becomes a part of you. From that moment forward, the prospect of having to get rid of it becomes a wrenching thought," he adds.
In fact, people don't stop at holding on to a losing investment. They make things worse by investing more in it a bid to average out the cost. In technical terms, this is referred to as the 'sunk cost fallacy' or trying to recover a bad investment by throwing in more money.

Application in financial life
This theory is amply reflected in our day-to-day financial behaviour. People tend to keep their money in safe debt instruments rather than in equity, despite the promise of higher gains in the latter, because the risk, and the implied loss, in equities is enough to keep them away from the high returns. What they don't realise is that the low returns in safe options will not be able to keep pace with inflation, reducing the purchasing power of their funds several down the line.
Loss aversion also makes people remain stuck to stagnant careers instead of spending money on upgrading their skills and looking for a better job. The lure of an improved and a more lucrative career is not enough to make them part with the money for a degree or a part-time course.

How to escape the loss aversion bias
One way of not falling into the loss aversion trap is to keep the big picture in mind or have a long-term view of your investments. So, sit and actually calculate how much the loss in one fund or stock will impact your entire portfolio before you decide to stick with it. If you are dealing in stocks and don't trust your ability to get out of a losing script, resort to stop-loss order. It will force you into a decision and not allow you to become attached to a particular stock.

Another option is to look for ways to turn your losses into gains. Short-term capital losses make on selling shares and equity mutual funds in less than a year's time can be set off against short-term capital gain as well as taxable long-term capital gain. "The easiest way to do that is to remember that selling investments at a loss creates a tax-deductible event"

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