Let me start today’s post by asking you a question.
Assume that India is preparing for the outbreak of an unusual Asian virus, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed:
- If program A is adopted, 200 people will be saved.
- If program B is adopted, there is a one-third probability that 600 people will be saved and a two-thirds probability that no people will be saved.
Which of the two programs would you favor?
Well, if you think like 72% among a few hundred smart physicians who were asked a similar question by the Nobel Prize-winning psychologist Daniel Kahneman, you will choose option A, the safe-and-sure strategy.
Most doctors would rather save a certain number of people for sure than risk the possibility that everyone might die.
Now consider this second question…
India is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed:
- If program C is adopted, 400 people will die.
- If program D is adopted, there is a one-third probability that nobody will die and a two-thirds probability that 600 people will die.
Which of the two programs would you favor?
Do you see the dilemma here?
Saving one-third of the population is the same as losing two-thirds.
Yet, doctors reacted very differently depending on how the question was framed. When the possible outcomes were stated in terms of deaths (and not survivors), physicians were suddenly eager to take chances: 78% chose option D.
“Are such smart people like doctors so inconsistent?” you might wonder.
Well, Kahneman and his longtime collaborator, Amos Tversky, explain these contradictory responses in terms of “loss aversion”.
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In other words, they suggest that the reasons the doctors were so inconsistent was that, for us humans, losses hurt more than gains feel good.
So we are more unhappy seeing our stock fall 30% than we are happy seeing it rise 30%.
I suffered from this mental disease for long, but with regular observation of my emotions and some efforts to overcome them, I can say that I’ve got over it. (At least this is that I will continue to believe till I face my next bad stock!)
Imagine if I continue to practice ‘loss aversion’ by selling off my winners and holding on to my losers. I will end up exactly as most junk collectors do – with a portfolio of rubbish.
Over the long term, this strategy is exceedingly foolish, since it ultimately leads to a portfolio composed entirely of shares that are losing money.
But the fact remains that people hate losses so much that merely framing a choice in terms of a potential loss can shift their preferences.
Like those physicians, people are suddenly willing to risk losing everything (from falling stocks that might never come up) if there’s a chance they might lose nothing (“I think this stock will rise again!”).
Since Kahneman and Tversky began studying loss aversion in the early 1970s, it has been used to explain a stunning variety of irrational behaviors, from the misguided decisions of investors to the stickiness of housing prices in the aftermath of a housing bubble (builders and owners are not ready so sell their houses at ‘loss’ even if there’s little hope that the prices will rise again).
“Loss aversion” is also used to justify our fondness for the status quo.
“The present may stink, but I still don’t want to lose it,” we would comfort ourselves during adverse times.
What makes us averse to losses?
One reason is regret.
We often regret a bad outcome, such as a stock that has fallen after we bought it. This is despite the fact that we know we chose the investment for all the right reasons.
In this case, what regret can lead you to do is to make a poor ‘sell’ decision. You may end up selling a good company at a market bottom instead of buying more of it.
Alternatively, if it’s a bad company and you realize it after you buy it, you regret being proved wrong in your original judgment.
So to avoid being called ‘foolish’ by your friends and colleagues, you hold on and continue to silently suffer the loss.
Another factor that makes you averse to losses is the ‘sunk cost fallacy‘, which we had discussed a few months back on Safal Niveshak.
Here is what this fallacy leads you to think…
It’s now too late! I’m already down 50%. Now I don’t want to convert the paper loss into real loss by selling the stock. And then, I spent so much time and energy finding this stock. Let me wait for some more time for it to come back to my cost price and then I’ll surely sell.
So you end up with a situation where just because you have put a lot of time and energy into the selection of the stock, even when you realise that you must sell it, you are afraid to cut it loose.
How to get over ‘loss aversion’?
In Why Smart People Make Big Money Mistakes and How to Correct Them, the authors write:
Once your money is spent, it’s gone. It has no relevance. To the extent you can incorporate that notion into your financial decisions, you’ll be that much better off for trying. If you’re debating the sale of an investment (or a home), for example, remember that your goal is to maximize your wealth and your enjoyment. The goal is not to justify your decision to buy the investment at whatever price you originally paid for it. Who cares?
What counts, in terms of getting where you want to be tomorrow, is what that investment is worth today.
The crux of this is that you must learn to walk away from bad investing decisions you made in the past.
Just get over that ‘I can’t quit’ trap.
Your sunk cost is already sunk in the past. Now, don’t sink your future worrying about it.
So, while making the decision to sell a stock, forget about what you paid for it. This is because what you paid for a stock has no bearing on the future price.
Only consider what the intrinsic value is today.
Ask yourself, “If I didn’t have these shares, would these be worth buying now, at today’s price?”
If not, then sell it now.
Don’t let your ego ruin your investment returns. You’ve already had it enough!