How to recognise loss aversion bias and what you can do to minimise its impact
Dubbed ‘get-even-itis’, loss aversion theory stems from our innate instincts to avoid losses by hanging onto a bad position
In its simplest terms, loss aversion is where you fear losses more than you enjoy gains.
Take doughnuts as an example. Who doesn’t like doughnuts? There is one left in the office, which you grab with your afternoon cuppa. Delicious. But the pleasure of eating it is pretty fleeting, and soon you’ll be thinking about what you are going to eat for dinner.
However, if you go to get the doughnut and someone else has eaten it – you’d be gutted. Right? And you wouldn’t be able to stop thinking about that doughnut for the rest of the day. That’s because loss is more powerful than gain. So losing the doughnut has a bigger impact than eating it. This is the basis of the loss aversion theory.
In trading this can mean not losing £1,000 is more important to you than gaining £1,000. And this can seriously affect your ability to trade.
What is loss aversion bias?
The loss aversion theory has been dubbed "get-even-itis" or "refund-itis" in trading because it stems from our innate instinct to avoid losses by hanging on to a bad position, even when there is no prospect of a turnaround.
Ekaterina Serikova, Currency.com’s trade behaviour analyst explains: “Loss-aversion inhibits the trader’s ability to move on and seize new opportunities, or at least prevent further losses.
“Loss aversion also causes traders to deviate from their trading strategy. This can mean exiting trades early, afraid of incurring losses or not seizing a new trading opportunity.
“Loss-averse traders set stop-losses too tightly or change previously settled stop levels when the wider price approaches them.”
Loss aversion bias was developed in 1979 by Israeli psychologists, Daniel Kahneman and Amos Tversky, as part of their prospect theory, which is the founding theory of behavioural finance .
This proposes that the pain of losing is psychologically around twice as powerful as the pleasure of gaining, so people are more willing to take risks to avoid a loss than to make a gain. The opposite is true when dealing with gains, as people become risk averse. They would rather get an assured, lesser win than take the chance at winning more, but also risk possibly getting nothing.
Buying insurance plans is a great example of prospect theory in action. Most people would rather agree to a smaller, sure loss – in the form of monthly insurance payments – than risk a large expense, in the event of an accident.
How to recognise loss aversion
While you cannot eliminate loss aversion, you can learn to recognise it and understand how it affects your decisions. Check out the following examples of how loss aversion can lead to making poor choices when trading.
1. Favouring low-return, safe stocks over more promising investments that carry higher risk .
2. Hanging on to stock that is below the price you paid, because you don’t want to suffer a loss.
3. Selling a stock that has gone up in price, in order to lock in profits, even though your analysis tells you to hang on to it for greater returns.
4. Selling winning investments instead of losing investments, to avoid accepting defeat.
5. Refusing a deal below your baseline, not because it’s a bad deal but because you can’t bear to make the concession.
6. Favouring low-return, guaranteed stocks over more promising investments that carry higher risk.
7. Focusing on one investment that has lost money, while ignoring other potentially lucrative investments.
8. Allowing your regret, following a loss, to cloud your judgment between a poor outcome and a bad decision.
9. Believing you haven’t lost until your investment is realised (ie it’s been sold).
10. Selling to avoid further losses when the stock price goes down, rather than buying more and waiting for the price to rebound – this is called "averaging down".
How to avoid loss aversion
To be a successful trader you need volatility and risk – without them, trading wouldn’t exist. The trick to accepting your losses is to create a trading plan, that includes losses – and stick to it. This will prepare you financially and emotionally.
“Avoiding loss-aversion is both simple and difficult at the same time – accept your losses and realise they are not as bad as they appear,” says Ekaterina Serikova.
When used wisely, stop losses are a great way to avoid loss aversion as they take the emotion out of trading in the heat of the moment. The point of a stop loss order is to help you worry less about volatility, as decisions are made for you. If the price of a stock dips below a certain price an order to sell is automatically made. Don’t set stop losses that are too wide or too narrow – and hold your nerve! Don't be tempted to move your stop loss, or cancel it.
Also, it’s worth bearing in mind that a stop order isn’t guaranteed. Markets move fast and a stop order may not be able to be implemented if your order is piled behind a load of other stop orders, or an order is too big and needs to be done manually.
The overnight test
US financial planner Carl Richards suggests using the "overnight test". Let’s say you’ve bought some stock based on the recommendation of a friend. After a few years the stock isn’t performing well and it doesn’t fit your investment plan. You want to get rid of it but feel you should hang on to it – partly out of loyalty to your friend and partly because you can’t face making a loss.
Richards believes that by changing your perspective from getting rid of the stock to investing cash, you gain a clearer view of the right course of action.
Imagine you went to bed and someone sold the shares overnight and replaced them with cash. The next morning, you can either buy the shares back, or keep the cash. Chances are it’s the latter, right?
As with all trading biases, a clear perspective will help you recognise your behaviour and make rational decisions. Before trading, write a plan, run through it several times and stick to it. You can't outrun your biases but you can learn to live with them.
FURTHER READING: Behavioural finance: how your biases affect trading
FURTHER READING: Trading biases to avoid as a novice trader