The STRIDE Blog

Loss Aversion: Why We Aren’t Naturally Rational Investors

stride-loss-aversion-why-we-arent-naturally-rational-investors-featured.jpg“People hate losing much more than they enjoy winning. How happy are investors when they make 3% on their investments and how miserable are they when they lose 3%? There is a tremendous asymmetry.” – Dan Ariely, Duke University

A traumatic financial loss can leave you overcompensating and focused on trying to protect yourself in the future. In the wake of your loss, you’re prone to making extreme decisions in an effort to and avoid the situation getting worse or prevent it from happening again… which is rarely a wise response.

No one likes, or wants, to lose. In light of this, understanding the motive behind loss aversion is relatively simple, however avoiding it is not.

What Is Loss Aversion?

Loss aversion is our natural response when experiencing any kind of loss; our dire attempts to save ourselves from further pain or our reluctance to accept what’s happening. While this is a natural defence mechanism, which is often useful in emotional situations, it can be deadly to investing. 

Just think back to the 2008 financial crisis. What drove the market to plummet so rapidly? Due to overconfident steps taken by various individuals and banks, stocks began to devalue quickly, and this caused people to enter a widespread panic. Sell, sell, sell. In an effort to save what they could, many investors flogged their investments, driving the share value even lower and causing panic to arise in still others. The natural response was to get rid of what you could, at the price you still could. Others thought to hold on a bit longer, as they had faith the value would again rise, but they gave in as the value plummeted and also sold. Few held on

throughout the crisis, yet those who stayed the course reaped the reward years later as the market soared once again.

The fear of loss causes investors, both professional and amateur alike, to make emotionally charged decisions and so to miss out on bigger opportunities. An emotional decision to satisfy the immediate future is counter-intuitive to your long-term investment goals, allowing fear to cause you to abandon ship before you can even see the port.

While the inclination towards this type of behaviour is very understandable, as no one wants to embrace a loss, it remains important to consistently remind yourself of how unproductive it can be for your long-term objectives.

How to Avoid Loss Aversion?

Do your research beforehand. Don’t panic. Don’t overcompensate. Don’t sell for just any reason, and be particularly cautious of the thought to “save what you can”.

Loss aversion usually happens when you’re not prepared to deal with market fluctuations or crashes. This usually comes about due to a lack of research and consideration. I say this because you shouldn’t be investing in any stocks that surprise you. Instead, if you do invest in a risky stock that might go either way, prepare yourself for the potential loss as well as the potential win. Or, be smart and invest in long-term stocks that you are certain will increase over time, despite their immediate states.

Live Long and Prosper

As a 3D value investor, it should be simple. In value investing, you should be picking your stocks based on a long-term strategy that doesn’t depend on the present or immediate future of these stocks. This means that you should have researched which companies you are confident are good long investments and, despite fluctuations in the short-term, will increase over time. Following this strategy should place a sense of calm, patience and confidence over your

investments, so that you don’t need to overreact in situations where others are trying to cover their present losses. Invest in the right stocks so that you can last through their fluctuations and come out on top.

It’s true that no one likes to lose, but if you let it overwhelm you and succumb to the panic that follows, you’ll only endanger your investments. Keep calm and carry on, by downloading our eBook below.

Topics: 3D Value Investing

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