Understanding Loss Aversion

Loss aversion is a common behavioral bias. Research suggests that the pain of losing is twice as powerful as the pleasure of gaining.

The market turmoil in March, 2020 is a perfect illustration of loss aversion.

As Helen Yang, CFA, wrote in an article published by Advisor Perspectives: “A tsunami of shock, fear and pain was triggered when S&P 500 lost 30% in 2020 due to the coronavirus outbreak. Did it generate a wave of joy of the same magnitude when S&P 500 gained 30% in 2019?”

Loss aversion prevents us from the economically rational decision as you can see from the mini-questionnaire.

Amateurs and professional investors alike suffer from loss aversion. In fact, rogue traders are more often the result of loss aversion than evil. It often starts with a small loss, and in an effort to cover it up, the trader would double down and take more risk, digging a bigger and bigger hole for themselves.

Understanding loss aversion helps us put our emotions in perspective, which helps to prevent irrational decisions.

By Helen Yang, CFA

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