Behavioral Insights: Loss Hurts
Humans hate to lose: the pain of losing is psychologically about twice as strong as the pleasure of making profit. Fear of losing has an unquestionable impact on investment decisions.
Dealing with Losses or Avoiding Losses?
Imagine you have to choose one of the following options:
- Option A: A sure gain of 10,000 dollars.
- Option B: Playing a lottery with an 80 percent chance of winning 12,500 dollars and a 20 percent chance of winning nothing.
If you are like most people, you will prefer option A. From a purely rational perspective, the two options have an identical expected gain, but option B is clearly more risky. And this additional risk tends to drive most people toward option A. The chance of winning an extra 2,500 dollars compared to the safe option is not worth the risk of winning nothing. This is a reflection of risk aversion, and it means that investors are only willing to take on additional risks if they are adequately compensated for it in the form of higher returns.
Now imagine that you have to choose one of these two options:
- Option A: A sure loss of 10,000 dollars.
- Option B: A lottery with an 80 percent chance of losing 12,500 dollars and a 20 percent chance of losing nothing.
If you are like most people, this time you will prefer option B. However, a risk averse investor should choose option A over option B which is riskier while offering the same expected return. Yet, by just switching from a potential gain to a potential loss, most investors switch from being risk averse to being risk seeking. So what is going on here?
The two examples demonstrate what is known as "loss aversion" and can be described as a natural tendency to avoid losses whenever possible. Instead of accepting a loss, we try to avoid them if possible, even if this means risking an even bigger loss. Numerous studies carried out in the laboratory as well as analyses of real life investment decisions, have confirmed that losses are perceived to be about one and a half to three times worse than similar gains. In other words, gains have to be one and a half to three times higher than potential losses before an investor accepts a risky investment. This fear of losing is rooted in amygdala, one of the most ancient parts of the human brain. It performs a vital function as it triggers emotions of fear and anxiety, and helps humans survive in potentially life threatening situations.
To Sell or Not to Sell, That Is the Question
Most investors have to face loss aversion in their own investment portfolios when they incur losses. For long term investments the best course of action is to stay invested through the ups and downs of markets. But what if an investment is short term or has a limited investment horizon and the remaining time is shorter than the time needed to recover?
Imagine that an investor has bought a specific stock with the intention of holding it for three years. In the first year, due to a string of bad news or a general market downturn, the share price falls by 20 percent. In order to break even after three years, the stock needs to have an average return of 12.5 percent per year over the remaining two years or even higher if the investor wants to make a sizeable profit over the entire three-year holding period. In many cases, stocks that have declined significantly are unlikely to recover over a short time, yet most investors refuse to sell a stock with a 20 percent loss or more. Instead they tend to hold on to it, and what started out as a short-term investment is mentally turned into a "long-term investment."
Investors who bought technology stocks in the late 1990s or financial stocks in 2007 experienced losses that were much higher than the 20 percent given in the example above, but their loss aversion made them hold on to these stocks even though they originally had no intention of staying invested in these stocks for many years or even decades.
The Upside of Losses
Loss aversion leads investors to hold on to losing investments for far too long even if there is an incentive to sell losing investments. In the US and other countries, investors can use realized losses from one investment to offset and reduce capital gains taxes from other investments. This tax incentive gives rise to so-called tax-loss harvesting strategies that can help reduce tax burdens and increase after-tax returns.
Yet, loss aversion can be so strong that many investors prefer to hold on to losing investments instead of reducing their tax load. In a study of 10,000 brokerage accounts in the US, Terrence Odean found that individual investors are almost twice as likely to sell a stock that has a profit than to sell a stock that has suffered a loss. This leads to an average investment period of 124 days for losing stocks compared to 104 days for winning stocks for these short-term investments. As, in the short run, momentum effects imply that losing stocks will continue to decline in price while winning stocks will continue to rise, this leads to a significant underperformance of individual investor portfolios.
Stop-Losses Can Help Investors
In order to avoid such negative effects on short-term investments, using stop-loss orders is highly recommended. In a stop-loss order, a stock is sold automatically as soon as its price drops below a certain point. The decision to sell a losing stock is automated and not influenced by loss aversion that can run high in the heat of the moment. Stop-loss orders have proven to be an effective tool for short-term investments and are used frequently by experienced traders.
However, stop-loss orders have two downsides. First of all, they tend to be counterproductive when used for long-term investments. For long-term investments, the best course of action is to ride out short-term market volatility. If a stop-loss is set too close to the initial purchase price (e.g., 5 percent below the initial purchase price), a small correction can lead to the sale of an otherwise well-performing long-term investment. The second drawback of a stop-loss is that sometimes it can be triggered just before the recovery. So, in the worst-case scenario, an investor realizes all the losses but does not participate in the subsequent recovery. This is the most frequent argument brought forward against stop-losses, but empirical evidence provided in studies such as those by Terrence Odean show that, on an average, investors are better off using stop-losses.
Know Thy Loss Aversion
Loss aversion affects everybody and is not always harmful. But there are circumstances when loss aversion can lead to investment mistakes. Most importantly, if the performance of an investment is checked too often, investors tend to fall prey to myopic loss aversion and miss significant long-term opportunities. Similarly, for shorter-term investments, stop-loss orders might help avoid excessive losses when there is not enough time to recover from them before an investment has to be liquidated.
Knowing how loss aversion affects investors when it comes to long-term and short-term investments is key to achieving better investment outcomes. A long-term investor who knows about the dangers of frequent performance checks will probably look into it only once per year or once per quarter, to reap the benefits of the long-term equity risk premium. A short-term tactical investor, on the other hand, will probably have stop-loss orders in place to limit short-termlosses and will have sufficient capital available to invest in other investments and avoid being wiped out by one bad short-term investment.