The Frontal Cortex : Loss Aversion and the Stock Market
Over the next few days, lots of people are going to be poring over their investment portfolio, trying to figure out which stocks to keep and which stocks to sell. Unfortunately, many of these investors will make the exact same mistake, causing them to lose vast sums of money over the long term.
The problem is loss aversion. Kahnemanandtversky stumbled upon loss aversion after giving their students a simple survey, which asked whether or not they would accept a variety of different bets. The psychologists noticed that, when people were offered a gamble on the toss of a coin in which they might lose $20, they demanded an average payoff of at least $40 if they won. The pain of a loss was approximately twice as potent as the pleasure generated by a gain. Furthermore, our decisions seemed to be determined by these feelings. As Kahneman and Tversky put it, "In human decision making, losses loom larger than gains."
Loss aversion also explains one of the most common investing mistakes: investors evaluating their stock portfolio are most likely to sell stocks that have increased in value or, during a week like this, have gone down the least amount. Why? Because it hurts to take a loss. Unfortunately, this means that people end up holding on to their depreciating stocks. Over the long term, this strategy is exceedingly foolish, since it ultimately leads to a portfolio composed entirely of shares that are losing money. (A study by Terrance Odean, an economist at UC-Berkeley, found that the stocks investors sold outperformed the stocks they didn't sell by 3.4 percent). Even professional money managers are vulnerable to this bias, and tend to hold losing stocks twice as long as winning stocks. Because selling shares that have decreased in value makes the loss tangible - and losing sucks - we try to postpone the pain for as long as possible. The end result is more losses.