Let’s say next week you make $1,000 in the market. And the following week, you lose $1,000. Of course, making money was better than losing money. But was the joy of winning greater than the pain of losing?
For most people, it isn’t – losing feels worse. And hating losing more than loving winning can lead to bad investment decisions.
The way our brains perceive loss (“giving back” to the market) is crooked. Research suggests that our minds experience actual pain when losing money. And studies have shown that the pain we feel while losing is greater than the pleasure we feel while winning an equal amount.
This is called loss aversion. In investment terms, people over-exaggerate the risks of a particular investment, even if the odds are in their favor, and decide to play it safe. So even if the chances of making $1,000 are better than losing $1,000 in an investment, most investors will avoid the opportunity altogether. Most people exaggerate the smaller possibility of a worst-case scenario, and as a result do not participate in what is, statistically, a good opportunity.
An experiment involving $50 and a coin toss demonstrated this. Scientists handed subjects a $50 bill and gave them two options: Keep (or “win”) $30, or toss a coin to win or lose $50. 43% chose to gamble, and the rest “won” (or kept) the $30.
When the experiment was repeated, participants were again handed $50 and again were given two options: “Lose” $20, or toss a coin to win or lose $50. The outcomes of the two different experiments were identical – “winning” $30 of the original $50, or “losing” $20 of the original $50. However, when the option was framed as “losing” $20 rather than “winning” $30, this time 61% of the group chose to gamble. The desire to avoid a loss rather than solidify a win caused participants to make a poor choice.
What can you do to avoid making a bad decision because of loss aversion? Try the overnight test.
Say you invested in a stock that declined in value. Now you’re faced with a decision to sell at a loss, or continue to hold the stock. It’s painful admitting you were wrong, of course. But imagine you went to sleep, and overnight the stock was replaced with cash. In the morning when the markets open, would you now buy the stock at the current market price – or invest it somewhere else?
If you wouldn’t buy the stock even at this lower price, you should probably sell.
Thinking in cash helps overcome risk aversion bias, as we also wrote here.