Loss aversion
Losses hurt more than equal gains please. That's why people hold losers too long and sell winners too early.
Learning objective: After this lesson you can explain why loss aversion makes you hold losers too long and winners too briefly.
A loss of €100 feels roughly twice as strong as a gain of €100. That can be measured, and it's true of almost everyone.
The pattern behind it
A particular pattern follows. A loss only becomes real when you sell. So you don't sell and you hope. A gain, on the other hand, could disappear again, so you take it quickly.
An example with two stocks
Anna owns two stocks. One is 30 percent down, the other 20 percent up. She needs money and sells, of course, the winner. If she does that for years, she's left with a portfolio full of losers from which all the winners have vanished. The opposite of what she wanted.
A question to ask
One simple question helps: would I buy this stock again today at this price? If not, there's no good reason to keep it. Your purchase price is your private number. The market doesn't know it and takes no notice of it.
The basis is the so called prospect theory of Daniel Kahneman and Amos Tversky. People don't judge outcomes by their final wealth. They judge changes relative to a reference point, usually the purchase price. Losses weigh about twice as heavily as gains.
Risk seeking when behind
There's a second effect. Once you're in the red, you suddenly become more willing to take risks. The prospect of getting back to zero weighs more than the danger of losing even more. That's exactly what's behind the revenge trade, where you go in bigger after a loss to win it back quickly.
The disposition effect
It shows in the disposition effect, which researchers have found again and again in brokerage data. Stocks that are up are sold much more often than stocks that are down. For tax it's often unfavorable as well. If you realize losses, in many countries you can offset them against gains and save tax. Holding losers on principle throws that away.
Summary
- Losses feel about twice as heavy as equal gains.
- Your purchase price means nothing to the market.
- The test question is: would I buy again today at this price?
Did you get it?
What does prospect theory say about losses?
People judge changes relative to a reference point, and losses weigh about twice as heavily as equal gains.
Why do people become more willing to take risks after losses?
Because the prospect of getting back to zero weighs more than the danger of losing even more.
Which question helps with a stock that's down?
Whether you'd buy it again today at this price.
What others often ask about this
My portfolio is down. Sell or hold?
The purchase price doesn't matter for this decision, even if it feels important. Ask yourself whether you'd buy the investment again today. If yes, there's little reason to sell. If no, there's little reason to hold.
Why is it so hard to sell at a loss?
Because a realized loss feels more final than a paper loss. That's exactly what loss aversion describes.
Your task
You hold two positions: A was bought for $1,000 and is now worth $700, B was bought for $1,000 and is now worth $1,200. You need $700 and must sell one. Calculate by how many percent A would have to rise to get back to $1,000, and answer the lesson's question for both: would you buy it today at this price?
Sources and further reading
- Kahneman, D. and Tversky, A. (1979), Prospect Theory: An Analysis of Decision under Risk, Econometrica View source ↗
Check your understanding
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- DrawdownStage 3
- Risk-reward ratioStage 3
- Impermanent loss and smart-contract riskStage 5
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