Loss aversion
Losses hurt more than equally sized gains feel good. That leads people to hold losing positions too long and close winning ones too early.
A hundred-euro loss feels roughly twice as strong as a hundred-euro gain. That's measurable, and it's true for almost everyone.
The result is a specific pattern: a loss only becomes real once you sell. So you don't sell, and you hope. A gain, on the other hand, could vanish again, so you take it quickly.
The outcome is a portfolio full of losers, with every winner removed from it. The exact opposite of what you wanted.
One helpful question: would I buy this position today, at this price, from scratch? If not, there's no reason to keep holding it. Your entry price is your own private number; the market doesn't know it.
The foundation is Kahneman and Tversky's Prospect Theory. Decisions get evaluated not against absolute end states, but against changes relative to a reference point, and the value function runs steeper in the loss domain than in the gain domain. The estimated factor is typically around two.
On top of that, the value function is convex in the loss domain, which explains risk-seeking behavior after a loss: the prospect of getting back to the reference point gets weighted more heavily than avoiding an even larger loss. That's the formal core of the revenge trade.
The observable expression is the disposition effect, well documented in brokerage data: the probability of selling a position is considerably higher when it's showing a gain. In many jurisdictions, this behavior is also tax-disadvantageous, since realizing losses creates offsetting opportunities that then go unused.
Summary
- Losses feel roughly twice as heavy as equally sized gains.
- Your entry price means nothing to the market.
- The check question: would you buy this today, at this price, from scratch?
Did you get it?
What does Prospect Theory say about losses?
They get evaluated relative to a reference point and weigh roughly twice as heavily as equally sized gains.
Why does someone become more risk-seeking after a loss?
Because the value function is convex in the loss domain. Getting back to the reference point gets overweighted.
What question exposes a held losing position?
Whether you'd buy it today, at this price, from scratch.
Sources and further reading
- Kahneman, D. and Tversky, A. (1979), Prospect Theory: An Analysis of Decision under Risk, Econometrica View source ↗
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