Loss aversion is a common behavioral bias. Research suggests that the pain of losing is twice as powerful as the pleasure of gaining. The chart below shows that the feeling for losing 100 dollars/pounds is twice as strong as gaining 100 dollars/pounds. In behavioral finance, this is also known as the Prospect Theory.
The market turmoil during the COVID-19 is a perfect example. When S&P 500 lost 30% in early 2020, the fear and pain is extremely strong. But the level of joy when S&P 500 gained 30% in 2019 was nowhere nearly as strong, nor when the market recovered strongly later in 2020.
Loss aversion is a widely researched phenomenon, which can be easily detected with this mini-questionnaire.
A common trait shared by amateurs and professional investors, it is deeply rooted due to our survival instinct. 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.
Having this awareness helps clients put their emotions in perspective. Knowing that the emotion is not an accurate gauge of the reality helps to prevent irrational investment decisions.
By Helen Yang, CFA