Equity Research Tutorials
- Equity Research Fundamentals
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- Sec Filings
- Red Herring Prospectus
- 10K vs 10Q
- Insider Trading
- Capital Gains vs Dividends
- Loss Aversion Bias
- Investment vs Speculation
Without much ado, we will get started with “loss aversion” and its different aspects.
- What is “loss aversion”?
- Prospect theory
- Why understanding “loss aversion” is important?
- Myopic Loss Aversion
- Avoiding loss aversion
- Conclusion – Loss Aversion
What is “loss aversion” bias?
Loss aversion bias expresses the one liner – “the pain of losses is twice as much as the pleasure of gains”. As an example, we can talk about a phenomenon we see among investors. If you ask new investors to invest into equity market, the first response they will give is this – “No, I don’t want to fall prey to the losses of equity market.” The most hilarious part is they don’t even know anything about the equity market; but still they want to avoid losses/risks at all cost.
Loss aversion bias brings us to the classic cases of three biases. Let’s look at them one by one.
#1 – Endowment effect
This bias is very common. Let’s say you have an old TV and you want to replace the old one with a new one. Whenever you would look at the exchange value, you will say that the value isn’t enough. This is a case of endowment effect. Because we seem to overvalue what we own regardless of its objective market value. In the year 1991, Kahneman, Knetsch & Thaler first talked about it.
#2 – Sunk cost fallacy
Loss aversion bias brings in another bias called “sunk cost fallacy”. It says that we seem to continue a demeanour as on-going commitment as a result of previously invested resources. The resources can be time, money, or effort. For example, let’s say you went to a restaurant and you order a lot of food thinking you and your family would be able to eat all. Then after a while, you realize that whatever you ordered is too much for the entire family. But instead you will try to finish all the food to avoid sunk cost fallacy. This bias is very common and you would be able to find out many more examples as you look into your personal and professional life. Through this bias, our pay-off is to save the money, time, effort we already invested instead of letting them go.
#3 – Status quo bias
This bias is more dangerous than the other two, because this bias tends to make people closed to other opportunities and solutions. It says that we tend to remain same by sticking to a decision we made earlier. For example, let’s say that you have taken an insurance plan. After few months, you realize that there’s another plan which will be much more beneficial in all aspects. But due to status quo bias, you wouldn’t take the new plan and would stick to the one you have already taken. Status quo bias is dangerous because it allows the inertia to hover over us and as a result, we can’t give ourselves a new direction even when that new direction can be more beneficial to us.
In these three biases, we will see one common thread – we seem to cling to things/ideas quickly and we don’t want to change these by naming them as loss/risk/challenge/obstacle.
To understand loss aversion bias, we need to talk about prospect theory which was propounded by Daniel Kahneman & Amos Tversky in 1979. For this Daniel Kahneman received Nobel Prize in the year 2002 (but Tversky couldn’t as by this time unfortunately he died).
Prospect theory talks about how people choose between different prospects and how they perceive the likelihood of different options.
We will take an example to illustrate this.
Let’s say that we have been given the options to choose from $900 in cash or 90% chance of winning $1000. According to prospect theory, we will choose $900 in cash even if the second option would offer us the same benefit.
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On the other hand, if we’re given the options of choosing between $900 loss and 90% chance of loss of $1000, we will choose the latter thinking that our chances of loss would get reduced by choosing the second option.
Prospect theory brings in three concepts which have been seen in people – certainty, isolation effect, and loss aversion bias.
#1 – Certainty effect
People seem to overvalue options that are certain than the options that are uncertain. This shows the risk-aversion of people for gains. For example, if people need to choose between a job that pays fixed salary and a business which offers a lot of money, people would choose the job with fixed salary as this one is most certain than the business opportunity.
#2 – Isolation effect:
If you look at the following image, you would get that people disregard any elements that remain common in both options.
In scenario 1, majority of people would go for option B. And in scenario 2, if people would choose option D, the benefit is similar, but majority would choose option C for their risk-averse attitude.
#3 – Loss aversion
We have explained the concept already. Just have a look at the advertisement given on Amazon. They use the concept “loss aversion” bias to persuade people to buy at the earliest.
Why understanding “loss aversion” is important?
We often think that we make logical judgments when we’re trying to buy/sell anything. But after understanding “loss aversion” bias , there’s a question mark in how logical/rational our thinking is.
Think about this. Let’s say a brand would suddenly increase the price. Previously when someone used to buy their shirts, they used to offer 10% discount on the prices. Now, they are offering the same shirt in 10% more prices. What do you would happen to the demand of the shirts? You guessed it right. It will drastically reduce. Now, let’s change the scenario. Let’s say that the brand suddenly decreases the price. Previously when someone used to buy their shirts, they used to offer the shirts in $15. Now, they are offering the same shirt in $12. What do you think will happen to the demand? It will certainly increase, but not as much as it would have been reduced in the previous scenario.
If you understand this scenario, you will be able to price your products in a way that would generate more revenue, increase demands, and help you stand out. At the same time, as a buyer, you would be more aware of these biases and wouldn’t fall prey to these while purchasing/choosing anything.
Before talking about how you can avoid loss aversion bias, let’s look at another related concept which is equally important.
Myopic Loss Aversion
Myopic loss aversion bias is a temporary situation where one loses sight of the big picture due to a certain event. Myopic loss aversion happens to people mostly in investment fields. Even with the most professional and informed investor falls into the trap of myopic loss aversion bias.
If you’re an investor and have been investing for a long time, you would know that during a sudden crash in the stock market, you panicked and tried to sell out all your stocks because you didn’t want to lose out on everything. Even if you call yourself a logical, rational, and experienced investor, still you did make a fool of yourself and you couldn’t see the big picture for the moment.
Well, if that happened, you can’t be blamed. Because it happens with all of the investors (professional & new)! To avoid myopic loss aversion bias, you need to know that you can’t make a buying/selling decision based on your emotion/how you feel during a panic-stricken moment. Whenever you’re experiencing myopic loss aversion, all you need to do is to let the moment go without making any hasty decision. Once you calm down and become normal again, you can think and decide.
Avoiding loss aversion
Avoiding loss aversion bias is tougher than avoiding myopic loss aversion bias because myopic loss aversion is a momentary thing; but loss aversion is much more ingrained in our subconscious mind and even when we’re trying to become sane, we still fall in the trap of loss aversion bias.
So how would one avoid loss aversion bias?
Loss aversion isn’t a thing of behavioral finance or behavioral economics only. It’s a philosophy that society encourages us to follow through (remember status-quo bias). Let’s say Team A is playing a football match with Team B. Now, Team A is defending Team B with all its might. And Team B is attacking all the time. Of course Team B will win the match, but both of these teams tried to avoid loss by –
- Playing not to lose &
- Playing to win so that they don’t need to go through the pain of loss.
The idea of loss is ingrained in the human mind and no matter what decision humans try to make (even when they think they’re making the most logical decision), they actually try to become loss averse all the time.
Asking you to avoid loss aversion bias is like saying that you need to get rid of the society. It is possible, but somehow we can benefit from loss aversion bias too.
Winning has importance too. As we have seen earlier in the football match example, loss aversion can help a team win (if they can strategize rightly). Loss aversion bias can also help a new investor avoid loss by becoming less greedy about earning more money.
Society only values the top performer. If you fail to become a top performer, you won’t stand a chance. In the bestselling book “The Dip”, marketing guru Seth Godin argues that quitting has different forms. If you can quit the right thing at the right time, you will win. Let’s say you have invested a hefty sum of money. Now you have noticed that for few consecutive months, the stock price has been declining. If you don’t want to lose a lot of money, you will immediately call your stock broker and sell the stocks which are declining. We will not call it bias; rather it’s prudence to quit at the right time.
However, quitting always doesn’t turn out to be useful. If you quit just because you’re loss averse without having sufficient proof to validate your decision, your chances of winning would be dim. For example, if you don’t start a business just because you don’t want to lose money and stay at a dead-end job, you will lose in real sense (even if you’re thinking that you’re avoiding loss).
One can’t speak generally about avoiding loss aversion bias. It’s very subjective and it differs from people to people and situations to situations. If you want to avoid loss, but at the same time don’t want to miss out on new opportunities, try to take a balanced approach. It’s given that you will not be able to win always and at every situation. But if you don’t take any risk because you’re trying to avoid loss, know that the greatest risk lies in riskless living.
Conclusion – Loss Aversion Bias
Loss aversion bias is connected with lot many other biases like certainty effect, isolation effect, status-quo bias, endowment effect, sunk cost fallacy etc. So to look at loss aversion bias rightly, you need to know the context of your decision as well as the content.
And no-one can tell you whether you’re right or wrong without first knowing why you did what you did. Loss aversion is not only a habit; it’s a psychology too. Knowing the psychology behind your particular behavior will allow you to pare down most of the biases and decide from the facts that are presented before you.
The best way is always to be informed about the irrationality of your behaviour. Read these behavioral finance books to know more about behavioral biases so that most of the time you can make prudent decisions.
- Thinking fast & slow” by Daniel Kahneman
- Predictably irrational” by Dan Ariely
- Influence” by Robert B. Cialdini