If you want to profit from investment, don't let loss aversion be your sole guide.
Don’t be a loser. Make your investing decisions in order to win.
No one likes to be a loser. Ask chess players or financial planners about losing and they will tell you that they hate it. In either field, regardless of how you prepare your strategy, plan your moves, and perform at your peak – whether you are sitting in front of the sixty-four squares or staring at the stock symbols on your screen – if the odds don’t roll in your favor, you lose. Interestingly, in both the worlds of chess and investing, the amounts that people find intolerable to lose don’t correspond with the number they hope to achieve by winning. The bitterness of losing, known as “loss aversion,” trumps the joy of winning in most situations, and this imbalance frequently causes people to make poor choices. Going for the least-chance-of-defeat decision may at first seem to be wise, but this strategy certainly won’t make you a winner.
Fear and Greed
The disproportionate way that people compare winning to losing helps to explain why investors act in a certain way. According to traditional wisdom, either fear or greed causes people to make an investment move. However, studies show that fear is about twice as strong a motivator as greed.
When investors are more fearful than greedy, they tend to panic when the market starts dropping and they sell. Loss aversion gets them to bail out when economic darkness prevailed.
On the other hand, when the markets recover, that is – after the markets have already gone up – these same investors buy back in, encouraged by their greedy side. However, “buy high, sell low” is a formula for failure on Wall Street. The stringent avoidance of risk can cause other problems, not the least of which is that people may not earn high enough returns on their investments because they keep them too safe.
As an investor, you need to understand the psychological barriers that cause many people to make poor decisions so that you can make choices that are not overly based on your own feelings. Alternatively, if you can’t avoid the emotional roller coaster of investing, either assign some or all of the day-to-day management to a professional or stay away from ventures with probability of risk altogether.
To find out more about how to make the best decisions regarding investment risk, read my article, Risk Tolerance and the Art of Tactical Asset Allocation.
Disclaimer: This article is for educational purposes and is not a substitute for investment advice that takes into account each individual’s special position and needs. Past performance is no guarantee of future returns.