If an investor has a diversified portfolio, an emergency fund and an investment strategy, the best move he/she can make in a choppy market is to make none at all
As an investor, would you rather not lose Rs 100 than gain Rs 100? Sounds familiar? According to behavioural finance, an investor who loses Rs 100, will lose more satisfaction than another person gaining satisfaction from a Rs 100 windfall. This is the concept of loss aversion and is encapsulated in the expression “losses loom larger than gains.” It is often said that the pain of losing is psychologically about twice as powerful as the pleasure of gaining. Several studies have found that people are more willing to take risks (or behave dishonestly) to avoid a loss than to make gains. The basic principle of loss aversion can explain why penalties are sometimes more effective than rewards in motivating people.
As a principle, loss aversion is important as it has critical implications for decision-making on an investment as it causes investors to overweigh the losses relative to gains. Investors are much more sensitive to reductions in financial wealth than to increases. This behaviour leads to flawed investment decision-making. Investors become irrationally risk averse and overly fearful and this is probably the reason for excess volatility and predictability of stock returns that cause stock market in the financial markets. Loss aversion behavior is measured using prior gains and losses: A loss that comes after prior gains is less painful than usual because it is cushioned by earlier gains. On the other hand, a loss that comes after other losses, is more painful than usual. Loss aversion behaviour can lead to stock prices moving from its fundamental values, causing abnormal returns and, hence, the stock market reaction, which results in variation returns.
Loss aversion is a different concept from risk aversion. When faced with two investment choices with similar returns but different risk profiles, a risk averse investor would go for an investment with lower risk. Risk aversion is a perfectly rational concept in investing. For example, if losing Rs 25,000 in your investment account means you won’t be able to make your monthly rent, while gaining an additional Rs 25,000 means you can go on an extra vacation, it makes perfect sense for one to play it safe rather than risk the roof over the head. As such, it is not irrational for investors to expect higher returns for taking on more risk. However, loss aversion holds that all else being equal, losses fundamentally loom larger than gains. This includes cases where, win or lose, the outcome will have little material effect on someone’s life circumstances and, thus, suggests that people are too risk-averse. To identify loss aversion, researchers have examined how people make decisions in the context of small gambles and have determined that loss aversion influences more consequential investment decisions.
In fact, the disposition effect — the tendency among investors to sell stock market winners too soon and hold on to losers too long — has also been attributed to loss aversion. But the disposition effect means wanting to both — realise gains and avoid losses — not favouring the latter over the former. There are other compelling loss aversion-free explanations for this. For one, investors may simply believe in mean reversion, that equities, which go up, must eventually come down and vice versa.
Several studies suggest that emotionally-driven financial fallacies can go hand-in-hand and people, who demonstrate loss aversion, are more likely to fall victim to the sunk-cost fallacy and vice versa.The sunk-cost fallacy is behaving as if more investment alters the odds of the investors, believing more the investment, the payoff would be higher. In essence, the same people, who flee from risk at the wrong moments, are more likely to double down on risk irrationally. But fearfulness is not the only threat to investors’ portfolios. According to Rui Yao, professor at University of Missouri, there are other traits like confidence and gender that predict the mistake of moving to cash without a need to do so during a downturn.
While slightly less than 10 per cent of the women made the error, more than 12 per cent of men did so. Investors, who demonstrate higher-than-average confidence, are also more likely to make the mistake as these confident people seemed to think that they can time the market and could get out and just get back in later. If emotion is a major factor that drives investors to “sell low,” it can also explain why people “buy high.” It is found that households, who just experienced investment gains, are twice as likely as others to invest all of their workplace retirement portfolio in stocks. Investing based on emotion is not without its consequences: Investors generally lag behind the benchmark index as instead of holding on to earn market returns, investors short-change themselves by trading in and out — at exactly the wrong times. So, if an investor has a diversified portfolio, an investment strategy and an emergency fund in place, the best move he/she can make in a choppy market is to make none at all, tide over the fear psychosis and take rational decisions.
(The writer is Assistant Professor at Amity University)
