Have you ever watched a movie in a theatre that you felt was complete nonsense and a waste of time? Did you ever walk out of the theatre? Very few people will because they have paid 200 per ticket. This is a classic example of loss aversion. In this behavioural bias, our feelings or biases towards loss can force us to make irrational choices.
If I were to give a very common example in the investment world, then it would be this. People do not exit bad or dud stocks because the current price is way below their purchase price. Investors know that the stock is a bad choice and there are better choices, yet they hold on to the stock in the hope that the market price will cross their purchase price or at least come close to it. At the same time, they will not buy more of this stock. If you have decided to stay in a stock, it means that you expect the stock price to appreciate. If this is the case, why can't the investor buy more of the stock when the price is down? This is because our mind is not trained to think rationally when it comes to losses and gains. Some other common examples of loss aversion are: Putting more money in an unfinished project or waiting too long for it Taking additional risk the moment one looks at a loss.
Harold Evensky's book 'Wealth Management' had a fantastic question:
Let's take a quick test. There are two parts to the test.
For each question, please check (A) or (B)
Part # 1
A) You win 80,000
B) You have an 80% chance of winning 100,000 (or a 20% chance of winning nothing)
Part # 2
Choose (A) or (B)
A) You lose 80,000
B) You have an 80% chance of losing 100,000 (or a 20% chance of losing nothing)
We have asked these questions to more than 5,000 people (including some very sophisticated investors) and the answers were not too shocking. There is consistency in how most investors think because 98% of the people opted for answer (a) to Part 1 and answer (b) to Part 2. If an investor suddenly sees a loss in Part 2, he turns into an aggressive investor who is willing to take on more risk. However, in Part 1, the same investor does not even bother to take a calculated risk even though you have an 80% chance of winning.
The point is that as soon as we see a loss, we stop thinking rationally as fear takes over and our ability to cut losses just goes for a toss. At this time, cutting losses is not an option as we just think on how we can avoid this loss. This is also because for some it is very difficult to accept that they have done a mistake. However humility is very important for an investor and an ability to accept mistakes is a key behavior trait that will eventually determinethe investor's performance.
Having looked at such behavioural decision-making shortcomings, I take pride in the fact that we do possess an ability to learn from our mistakes. It depends on how well we keep our 2 Es — Ego and Emotions — aside to make rational investment decisions. One key observation though is that we always spot these mistakes in others but never in ourselves. Hence, we must train our minds to accept the fact that we, too, can go wrong and that it's ok to go wrong sometimes.
