How ‘Loss Aversion’ Affects Your Investments
Many investors are not risk averse, they are ‘loss averse’. It makes investors behave irrationally, against their own interests.
Investment advisors often witness strange behaviour among a large number of investors – many of them continue holding some poor quality stocks in their portfolios. When probed further, investors reveal that good stocks were sold fast, while the bad ones remained. What explains this?
Ordinarily, no rational investor would want to hold on to bad investments, while getting rid of good ones. However, extensive research by various psychologists, including Nobel Laureate Daniel Kahneman, and his late colleague Amos Tversky, suggests that the pain experienced due to a loss is twice more powerful than the pleasure for a similar amount of profit. Humans look to avoid pain, one form of which makes investors avoid acknowledging an investment loss at all costs.
Many investors are not risk averse, they are ‘loss averse’. It makes investors behave irrationally, against their own interests.
Over the years, I have seen investors buying many stocks in the hope of making money. While some are good investment choices, others could be mistakes. Very often, stocks are bought without much research. So, once the stock price goes up, investors fear that it may go down as fast as it went up. Such thinking makes them sell the stocks too soon.
Then come instances where the stock price has gone down after an investor has bought it. This tends to happen when the primary reason for buying the stock was a recent upsurge. Very often, stocks come into the limelight when prices moved up, and people buy. In such cases, there is a good chance that the stock’s price will go down after it’s been bought.
If a company is fundamentally strong, its stock price has a higher likelihood of recovering after the drop, than a company whose fundamentals are weak. However, loss aversion leads to investors continuing holding on to stocks of poor companies even after a price drop. Let us understand this further.
Good Stock, Bad Stock
The price of a stock moves largely on account of two major factors:
- Company-specific or stock-specific factors, and
- General factors to do with the external environment.
Company And Stock Specific Factors
These include the financial situation of a company, its overall business, government regulations pertaining to the company, etc. These may also include the acceptance of the company’s products or services in a marketplace, its relative position in the market vis-à-vis competitors, labour-related matters, availability of funds for expansion or regular working capital, etc. A detailed study of a company’s business and financial statements should help take care of these factors.
Stock-specific factors may also affect the prices, especially in case of companies with low floating stock – a large buy or sell order for the stock may move the price dramatically beyond its intrinsic value. This is an estimate of the firm’s value, based on the study of the financial statements and the business of the company. This value largely depends on the quality and sustainability of future cash flows, as expected by the person analysing the company.
While the factors specific to the company’s business and financials may have a longer-term impact, the stock-specific factors may have only a temporary one. A company that has strong business fundamentals – where the product has a good market; there is less (or no) pressure on the profit margins of the company; fewer competitors; or if the company is in a dominating position – it is likely to see a longer-term uptrend in the price of the stock.
General Factors
These impact the prices of stocks of companies across the market. These could be a change in the overall liquidity in the economy; change in interest rates; major political changes; policy changes; or a warlike situation, etc. Since these factors may impact the entire market, even the stocks of good companies take a beating.
This is when good investors buy stocks of good companies, i.e. when the markets are going through a bad phase. On the other hand, a large number of investors, who eventually end up losing money, would have bought stocks of poor companies when the market is high.
‘Buying At A Discount’ Syndrome
The other behaviour that stems from loss aversion is that investors end up throwing good money after bad.
Suppose, one has bought the stock of a company at Rs 100, in the expectation of seeing a rise in the price. Let us assume that he/she expects the company to do well in the future, and hence expects the price to move up. However, what happens if the assessment was improper or inadequate and the company’s business fundamentals are poor? In such a case, the company’s business stumbles, and then the stock price drops to, say Rs 90, while the investor continues to believe that the company’s business is good. In such a case, one tends to think (since he/she is not aware of his/her mistaken view) that Rs 90 is an even better price, since this is a discount compared to the original price at which one had bought the stock. This looks like a rational behaviour – buying something at discount.
One tends to forget that the discount is in comparison to a price one paid earlier, and not necessarily a discount in comparison to the value of the investment.
This is especially true in case of the stock of a poor company. As the stock price falls, it keeps getting cheaper. However, it is not cheaper than the intrinsic value of the business, it is cheaper in comparison to the previous purchase price. The way to look at it should be to check whether the price has become cheaper or it was costly earlier and now it has normalised.
The ‘loss aversion’ investment bias could prove to be really harmful to one’s wealth. Understand the bias and protect your wealth.
Amit Trivedi is a certified financial planner, owner of Karmayog Knowledge Academy and author of Riding The Roller Coaster, Personal Finance Lessons from the ICU, and The Whole Thing Is That Ki Bhaiya Sabse Bada Rupaiya.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its Editorial team.