December 26, 2015

Loss aversion and stock markets

Investors tend to focus obsessively on one investment that's losing money, even if the rest of their portfolio is in the black. 

This behavior is called loss aversion.

Investors have been shown to be more likely to sell winning stocks in an effort to "take some profits," while at the same time not wanting to accept defeat in the case of the losers. 

Philip Fisher wrote in his excellent book Common Stocks and Uncommon Profits that, "More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason."


Regret also comes into play with loss aversion. It may lead us to be unable to distinguish between a bad decision and a bad outcome. We regret a bad outcome, such as a stretch of weak performance from a given stock, even if we chose the investment for all the right reasons.

In this case, regret can lead us to make a bad sell decision, such as selling a solid company at a bottom instead of buying more.

It also doesn't help that we tend to feel the pain of a loss more strongly than we do the pleasure of a gain. It's this unwillingness to accept the pain early that might cause us to "ride losers too long" in the vain hope that they'll turn around and won't make us face the consequences of our decisions.

Example

The U.S. 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. Assume that the exact scientific estimates of the consequences of the programs are as follows: 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?

When this question was put to a large sample of physicians, 72 percent chose option A, the safe-and-sure strategy, and only 28 percent chose program B, the risky strategy. In other words, physicians would rather save a certain number of people for sure than risk the possibility that everyone might die.

But what about this scenario:

The U.S. 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. Assume that the exact scientific estimates of the consequences of the programs are as follows: 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?

When the scenario was described in terms of deaths instead of survivors, physicians reversed their previous decision. Only 22 percent voted for option C, while 78 percent of them opted for option D, the risky strategy. Most doctors were now rejecting a guaranteed gain in order to partake in a questionable gamble.

Of course, this is a ridiculous shift in preference. The two different questions examine identical dilemmas; saving one third of the population is the same as losing two thirds. And yet, doctors reacted very differently depending on how the question was framed. When the possible outcomes were stated in terms of deaths this is the "loss frame" physicians were suddenly eager to take chances. They were so determined to avoid any alternative associated with a loss that they were willing to risk losing everything.



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