Here’s some examples to help explain what loss-aversion bias is; chances are, you’ve experienced one of the following scenarios at some point!
- Imagine that you just bought a stock, only to have it almost immediately start increasing in price. You’re pleased that you have a nice gain and take a moment to pat yourself on the back! Then, something happens, potentially in the news or the market, that makes you nervous. So, you turn around and sell this stock to realize the gain. A few months go by, and the stock that you so proudly sold for a nice gain is up even further. You think to yourself: “Darn, I shouldn’t have sold that stock!”
- Or how about another, where you bought a stock and it instantly starts to go down. You don’t sell it right away, because you don’t want to take the loss. You continue holding it, and eventually six months goes by — at which time the stock has gone down even further. At this point you own some big loser that you don’t want to get rid of, in hopes that it comes back one day. You think to yourself: “I should have sold that stock a long time ago when it was only down slightly!”
How loss-aversion bias changes investor behavior
We’ve probably all experienced both situations. In any case, it’s helpful to understand the phenomenon, what causes it, and how to learn from it. The goal? To help you avoid these mistakes in the future and lead to better investment decisions.
These two example scenarios have been studied for many decades and are referred to as “loss-aversion bias”. Investors are often too quick to take gains, because it feels great to lock in gains before they might disappear. At the same time, investors often hang on to failing stocks for far too long, in hopes of avoiding an eventual loss. Another way of looking at it: “it’s better to not lose a dollar than to find/gain a dollar.”
What investors can learn from loss-aversion bias
One potential strategy, when appropriate, is to do the opposite of what our instincts tell us. Some investors thus choose to let their winners “run,” being patient in order to seize the opportunity of future upside gains. Then, those same investors may choose to sell losing stocks quickly — as hard as it is — to avoid further losses down the road.
Perhaps the most important lesson to learn is how we tend to behave as human beings. You can keep this in mind as you decide what to do with your investments, before being led astray by a temporary feeling!
How loss-aversion bias affects investors in the stock market
One could apply these concepts to the stock market as a whole today, instead of just for individual stocks. The market has been going up for several years now, so I often hear from my clients that we’re “due” for a market pullback — simply because it’s been going up for so long.
Investors can also exhibit these biases due to current events. Take for example the China tariff situation, the U.S. election coming up next year, and the Fed deciding what to do with interest rates. In this environment of fear and anxiety, many investors are looking to sell out of the market right away.
It may prove prudent for some investors to be patient and let this bull market continue to “run” before exiting, but the optimal route all depends on each investor’s individual situation! Talk with your Allen & Company financial advisor about the optimal strategy for your investment portfolio.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. No strategy assures success or protects against loss. Investing involves risk including loss of principal.