#3 - Loss Aversion: Exploring and Refuting Common Investor Behavioral Biases

R.P. Seawright of Above the Market recently released his list of “Investors’ 10 Most Common Behavioral Biases,” a valuable juxtaposition of most common investing mistakes with the behaviors and attitudes behind those same mistakes. This article is a series of expansions and explorations of each bias.

Investor Behavioral Bias #3: Loss aversion

Fall 2008 marked the beginning of the most adverse economic downturn in decades. From 2007 Q4 through 2009 Q2, investment values decreased by as much as 42.2 percent. (Columbia University School of Business) Now, seven years later, the stock market has largely returned in value beyond its pre-recession levels in 2007.

What hasn’t returned is investors’ rose-colored optimism towards investment options. The idea of guaranteed loss at some point over the life of an investment can lead to loss aversion among investors. A tell-tale sign of loss aversion is inaction regarding financial investment decisions. Many investors would rather make no investment decision than risk losing value.

As Harvard professor and author Cass Sunstein purports, “...people dislike losses more than they like equivalent gains. Golfers really don’t want to lose a stroke to par. Teachers don’t want to lose money they now have. Even a small tax counts as a loss, and it affects people’s behavior.” (Source) The same is true in financial investing. The threat of financial loss is valued as greater than the potential of financial gain, the crux of loss aversion.

Other investors face a unique perspective by compounding loss aversion against optimism bias. The end result is a conflicted investor with a bullish market outlook and bearish investment practices. As with any behavioral bias, the root cause is psychological, not fiscal in nature, which is why investors must understand the likelihood and purpose of loss in financial investment.

Any investment purchase can be affected by factors beyond an investor’s control, such as transition of CEOs, mergers or acquisitions, and as evidenced in most recent years, an economic recession. An excellent solution in combatting loss aversion is evaluating empirical data under the careful direction of an experienced financial advisor. Sound financial investors understand an occasional loss is to be expected but the long-term financial gain is worth momentary and infrequent value loss.