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Monday, July 16, 2012

Psychology of Investing: Loss Aversion


“Oh the tangled web we weave when first we practice to deceive” Sir Walter Scott eloquently penned the tragedy of deception. The most telling deception though is self-deception. We suffer with this tragedy on a daily basis.

No more telling aspect of self-deception than that of loss aversion. Basic human nature holds that we move towards pleasure and away from pain, yet in this avoidance we feel and remember the pain more consistently than the pleasure. One of the basic laws of psychology is simply that we get more of that which we focus on then that which we do not. The most telling thoughts in one’s mind manifest the reality of experiences for that individual. Therefore it follows that when we spend psychic energy in the practice of avoidance we get more that which we seek to avoid.

A simple example of this is laying golf, for you duffers reading this I’m sure you have experienced the dreaded “don’t hit it in the water” trap. The message that the mind is focused on is hit it in the water not, as the sub-conscious mind does not differentiate between good and bad, negative and positive. So when you focus on what do don’t want to happen, you end receiving the very thing you were avoiding and presto the ball is in the water.

So it is with the concept of loss aversion. The investment psychology for many is to obsess upon the poor stocks and ignore the totally successful aspects in the portfolio. We are perfectly willing to sell and take some profits, but bitterly opposed to selling off losers. This also leads to the most dreaded of all behavior the buy high sell low syndrome. Loss aversion is the basic foundation to this process of consistently buying high and selling low.

Regret plays a role in our loss aversion mentality. It is regret that leads us to non-distinguish between a poor decision and a poor outcome. By falling into regret over a poor outcome we tend to overlook the good investment decision on a company and suffer during a weak performance which many times lead to selling off low as opposed to increasing a position at the bottom of a good investment.

As previously discussed we tend to feel pain more than pleasure and this combined with regret tends to lead us down the path of staying too long when we refuse to move on the early pain.

Recognizing these behaviors is the first step in proactively taking control of our thoughts and processing information in a new and improved style.