Loss aversion

The first million in gains, and what then?

Kahneman's experiments also show that there is a decrease in both “gain sensitivity” and “loss sensitivity”: Gains delight us, but the subjective benefit we derive from them decreases as our gains increase. In other words: The first million we gain pleases us more than the second, and the second pleases us more than the third. According to brain researchers, the so-called dorsal striatum in the frontal cortex is to blame for this: It is part of the brain's reward system and gets activated when we gain something. However, the more we gain, the less active it becomes. The same is true with regard to losses: A loss of, say, 100 euro is very painful. But the higher the sum we lose, the flatter the negative benefit curve. Whether we lose 1400 or 1500 euro makes much less of a difference than whether we lose nothing or 100 euro.

This explains why people are risk-averse when it comes to gains but risk-taking with regard to losses. When presented with the choice of either a) winning 1000 euro or nothing on a coin toss, or b) being given 500 euro in cash no matter what, most people play it safe and go for option b. However, when they are to choose between a) losing 1000 euro or nothing on a coin toss, or b) losing 500 euro no matter what, they tend to take a risk and opt for a) because doing so at least gives them a chance of not losing anything.

Sold at the wrong time

This also has an impact on the financial markets: Numerous studies show, for instance, that there exists what is known as the disposition effect: After a share has dropped in value and investors have suffered a financial loss, they tend to wait for too long before divesting themselves of it. Conversely, they are inclined to sell too early profitable shares whose value has increased above the buying price. The following pictograph illustrates this asymmetry.

Loss aversion helps explain this phenomenon: Prior to making a decision, for example to buy or sell shares, we invariably create a reference point and relate potential gains or losses to it. When it comes to selling shares, this reference point can, for instance, be the buying price. If the share's current value is higher than the buying price, we will make a profit. Hence, we are risk-averse and tend to sell the share too early because we want to reduce our risk. Conversely, if the share's current value is lower than the buying price, we will incur a loss. In this case, our willingness to take risks increases, and we tend to keep the share for too long, hoping that it will eventually regain in value.

Tips

Here are some pieces of advice to help you avoid falling victim to loss aversion when trading in shares: Always use a share's fundamental value—not past prices—as the basis for deciding whether to buy or sell it. Buy the share if its current price is lower than its fundamental value—chances are, the share's price will go up. Sell the share if its current price is higher than its fundamental value because in this case, the share’s price is very likely to fall.

To protect yourself against the disposition effect discussed earlier, adopt a “what if” strategy. When you are contemplating selling a share, ask yourself: Would my decision be any different had the share's buying price not been what it was but X or Y euro? If your answer is “yes”, you had better be careful: You may very well fall into the disposition trap!

This article was published in the Austrian business magazine GEWINN. Read the original article here (in German).