How to Easily Avoid Loss Aversion

During the December market correction, what did you do?

Did you sell everything? Did you dig in and buy more stocks?

Chances are that you followed all the fear-mongering news stories and sold at least some of your positions.

Or worse, you hung onto some real losers and refused to let go.

This is a typical pattern for something called “loss aversion.” Loss aversion is the idea that losses have a larger psychological impact than gains of the same size.

Think of a coach who says, “I like to win, but I hate to lose.”

It’s a human response. We hate to lose… especially money.

Today, I’ll share an interesting twist on this mental hang-up. We’ll walk through how it can get in the way of your investing returns… And I’ll show you to get around it with the help of one simple step.

Loss aversion doesn’t just prevent us from cutting our losses – it can even prevent gains.

In a study by the DrKW Macro research firm…

Three hundred fund managers were asked this question… “You are offered the following bet. On the toss of a fair coin, if you lose you must pay £100, what is the minimum amount that you need to win in order to make this bet attractive to you?”

In a perfectly rational world, even just £101 (about $129) would make for a good bet if you could make it repeatedly.

But the fund managers wanted almost double that… an average of £190. They weren’t willing to risk a loss unless the money was far in their favor. It turns out, people dislike losses about two times more than they enjoy gains.

Loss aversion applies to investing as well…

We’ve all held a stock that’s headed down. And we’ve all – at some point or another – kept holding, hoping to break even. “If it could just get back to my buy price, I would sell and move on.”

That whole time, you’ve got your capital tied up in a stock that the market has soured on. Meanwhile, other stocks are shooting up left and right.

But many investors just can’t cut their losses and move on.

Folks become emotional with stocks that turn into losers. And it’s not just you…

In a seminal study by professor of finance Terrance Odean, an analysis of 10,000 individual brokerage accounts found that investors held losing stocks for a median of 124 days versus a median of 102 days for winning stocks.

We’re too quick to sell winners for fear that we’ll give back some of our gains.

However, in more recent studies, we’ve learned that it’s not just loss aversion driving us…

It turns out, we can stand to lose money… as long as we don’t lose more than our neighbors.

That’s why some folks jump out of the market at the slightest correction – they don’t want to risk losing everything, especially if they’ve already seen their portfolios wiped out in a prior crash.

And if everyone else is selling, well, you don’t want to be the only fool left holding the bag.

Researchers out of Duke University found that most of it comes from communities. People with a lower income living in a wealthier neighborhood – struggling to afford the best cars, houses, and more – find that the competition weighs heavily on them.

These folks tend to follow the crowd more… especially when it comes to investing. And they’re happiest when they lose less than the guy next door.

It’s “keeping up with the Joneses” in finance form.

Fortunately, you can easily avoid loss aversion by using simple position-sizing.

Never put more than 4%-5% of your investment portfolio in any one position (single stocks and bonds). This step ensures you never lose more than a small fraction of your wealth on any one investment.

There are plenty of other tricks that take the fear out of investing. This one may sound simple, but don’t neglect it… It’s one of the easiest ways to fool your brain into behaving well.

You must realize that avoiding losses completely is impossible. Even the best investors occasionally lose money.

So don’t worry about what everyone else is doing. Simply learn how to limit your losses so they won’t threaten your financial future. That’s how you invest wisely (and sleep well at night).

Here’s to our health, wealth, and a great retirement,

Dr. David Eifrig

Source: Daily Wealth