Let’s make a bet.
We’ll flip a coin.
If it comes up “heads,” I’ll pay you $20.
If it comes up “tails,” you’ll owe me $10.
The odds of the coin toss are 50-50.
But the payoff potential is 2-to-1 in your favor.
Would you take that deal?
Most people would not, according to a library of academic research.
This unwillingness to play this game is linked to a very simple cognitive bias.
You see, behavioral economics and psychology research show that human beings are TWICE as fearful about losing money as they are about winning money.
This bias is known as loss aversion.
This bias won’t just make people avoid games, even if they offer favorable odds…
It can and will stifle your ability to maximize returns in the stock market.
Let’s dive in.
Making a Bet
Let’s revisit our game for a second.
Nobel Prize-winning economist Daniel Kahneman first proposed this heads-tails game to measure human risk.
He started his research by asking students how much money he would have to risk to get them to bet $10 on a coin flip.
The answer was typically higher than $20.
Here’s the thing: Even at $20, you should make this bet.
You should want to make it over and over again.
It might take a second to understand the math. But each flip provides a mathematical net benefit to you of $5 per flip.
That $5 is the “expected economic outcome” of each coin flip.
We obtain that number by calculating the 50% odds of the $20 wager minus the 50% odds of the $10 outcome, or ($20 * .5) – ($10 *.5) = $10 – $5 = $5.
The odds are in your favor the more times you play.
Now, you might ask: “What if I lose four out of five times? Or worse, five times in a row?”
That type of conflicted thought process drives individuals to avoid risk-taking, even if the odds favor them.
Human beings are very happy when they win.
But they’re very upset when they lose. And that fear makes them take fewer risks.
Does that sound familiar?
Think about your mood on days when your portfolio increases by 2%.
You’re pretty content, right? You think about how much you’ve made on paper.
Now think about those days where a selloff occurs. Even if you’re a long-term investor, the idea of being off 2% on paper elicits stronger emotions…
How Loss Aversion Impacts Your Investing
Consequently, loss aversion drives investors to make bad decisions around their investments and their strategies. This can include:
- An urge to invest in low-paying bonds, gold, or other “safe products” like cash. These assets offer little real return and can reduce your long-term purchasing power due to inflation.
- The unwillingness to sell a stock – ditching your losers – simply because you don’t want to take a loss. As a result, the stock might fall further and further, creating bigger losses and more regret. This ties into another example that people don’t believe they have lost until they sell.
- Selling stocks to avoid losses when signals suggest that you should either hold the stock or even build a position with strategies like dollar-cost averaging.
- Buying a stock and quickly selling it for a small gain simply to feel the satisfaction of having a winner.
- Calling a brokerage to talk about building a 401(k) retirement plan, and ending up purchasing a high-fee, ultra-conservative annuity plan.
It’s not just the stock market where we see loss aversion take hold.
- Due to a fear of “losing” money, many people won’t sell their homes at a loss, even if they need to leave town for another work opportunity. This can result in higher costs over the long run, especially if they cannot retain a tenant.
- An unwillingness to change the status quo in an expiring contract. As a business owner, I’ve known plenty of people who want or expect the same types of contracts when terms end and won’t make concessions or alter terms even if it benefits both parties in the deal.
- The sunk-cost fallacy might lead someone to purchase a beat-up car and pump lots of cash into it to keep it running. While it might make more sense to sell the vehicle, the inability to concede a financial loss will make people continue to engage in upgrades instead of buying a new car.
Why This Matters and How to Fix It
Loss aversion can lead you to avoid risk and build overly conservative portfolios.
TradeSmith provides the tools necessary to “set your portfolio and forget it.”
Instead of spending countless hours jumping in and out of stocks, our risk-based volatility scores (VQ) help you understand the risks associated with each equity or fund you own.
Your fear of loss aversion combined with the overconfidence we discussed on Monday can lead you to jump in and out of stocks.
TradeSmith helps you eliminate these biases and know the right time to buy, sell, and hold a stock.
Tomorrow, we’ll talk more about earnings reports in several major companies that issued updates. I’ll show you what TradeSmith thinks of each company and how easy it is to avoid the temptation to fall into the traps of cognitive bias.