Loss Aversion: How it Can Damage Your Investing and Trading Efforts and How to Stop It
Guess what? You're prone to loss aversion. If you're not sure what it is, it could cause you to lose a lot of money. Let's figure out how to stop it.
You may be a victim of the psychological phenomenon of loss aversion without even realizing it.
Have you ever wanted to guard your money instead of "risking it" in the markets? Have you ever held onto stocks even though they're major losers and unlikely to come back — all because you can't stand the idea of selling at a loss?
Or maybe you've sold a stock that has gone up slightly in price, even though all signs point to the fact that you should hold the stock to profit even more from it later.
Loss aversion may also mean that you invest in low-risk investments like bonds instead of going after stocks. Your fear of losses might encourage you to go the "safer" route when investing.
However, that may, in the long run, become detrimental to your portfolio. Let's explore this very real phenomenon and give you some tips on how you can avoid the loss aversion bias — you don't want to sacrifice your future.
What is Loss Aversion?
Pioneers Daniel Kahneman and Amos Taversky's "Prospect Theory: An Analysis of Decision under Risk" describes loss aversion in detail. The duo found that investors display more sensitivity to loss than to risk and possible return.
Loss aversion refers to the fact that, when making investment decisions, we most often focus on the risks associated with the investment instead of the potential gains we might get out of it. In other words, loss aversion means you believe that a real or potential loss is more emotionally and/or psychologically upsetting than the same amount of gain.
We feel the pain of loss more strongly that we do the pleasure of winning, and our brains do not give the same weight to a $1,000 gain as we do a $1,000 loss.
How to Guard Against Loss Aversion
Take a look at a few tips to avoid falling prey to loss aversion. Consider other ways you might be able to mentally guard against loss aversion on your own. You might develop other mental tips and tricks! Let's take a look at a few to get you started, however.
Tip 1: Stick to your stop level or target.
When trading, don't second-guess where you want to end up. Always follow your plan and stick to your stop-loss order to buy or sell once a particular stock reaches a certain price. As long as you have a plan, your order should make sense for you. However, if you have arbitrarily picked that target, you may feel uneasy about your choices. Make sure it fits your comfort level!
Tip 2: Practice patience.
When traders fear losses or try to make up for previous losses, exhibiting patience can help loss aversion ebb away. You're less likely to panic and trigger a sell because you fear losses. Keep a few tips in mind:
- Use small positions to feel out the direction of the market.
- Go in and out of positions slowly to learn how to build the right positions.
- Document everything. Keep a trading journal so you know when you will more likely make mistakes.
The more you practice, the more patience you'll "accrue" and start to eradicate feelings of loss aversion. Patience could also breed more confidence.
Tip 3: Keep emotion out of it.
Similar to building patience, you also want to keep your feelings out of the picture. Practice dealing with all the emotions of trading constantly so you handle the day-to-day trading environment better.
Not getting emotionally involved in your investments means you can slowly back away from loss aversion. You'll gradually realize that sometimes it's okay to take a loss. It just makes you a better trader.
Tip 4: Gather more experience.
Just like in most jobs, you get better with experience. For example, doctors and nurses get better with experience, and as a trader, you can gain experience and apply that knowledge.
You can more flexibly consider different scenarios that could play out almost any type of market condition. You can also plan out how you will implement your trading plan under various conditions as you gain experience.
Walking through what you need to do every time can help you develop your trading technique and also help you with the psychology of each trade.
When you always think 10 steps forward, you can act decisively and rid yourself of loss aversion over time.
Tip 4: Be honest about what could actually happen.
"What's the worst that could happen?" sounds exactly like something a teenager would say — right before falling off the proverbial cliff.
However, do understand what can actually go wrong. You probably won't lose $1 million. You can probably sift through the possibilities and take action on a trade better than you think you can. In other words, start thinking about what could go right instead of what can go wrong.
Tip 5: Be selective about what media you expose yourself to.
Throw away the scarcity mindset, which the media loves to promote. "Get into this stock now before you lose out!"
Among the efforts of making your mental game stronger, you also need to apply that strength to get rid of poor information. That includes the guy in the trading chat room, your day-trading brother-in-law and all the social media feeds you subscribe to. Filter the good from the bad.
Tip 5: Investors: Understand that risk can be a good thing.
As an investor (not a trader), educate yourself about risk and reward. Unfortunately, many investors have an aversion to risk when investing, even though taking on some risk is the very basis for how many investments accrue returns. In fact, many people prefer to keep the money they have instead of putting gains front and center.
It's good to remember that any investment, even so-called "safe" investments like bonds involve risk. You open yourself to the possibility that you could lose money.
Cut Out Loss Aversion
You know what loss aversion actually does? It inhibits you from taking risks — risks that could bring you all sorts of positive rewards.
Our fears of failure trump our possibilities of success. How crazy is that? If you want to be successful, know how loss aversion works and how it might actively hold you back.