I was discussing the stock market with one of my co-workers the other day, and we were talking about how stocks are generally overvalued and how the market will have to come back down eventually.
He said “This is why I don’t want to invest in the market right now. Everything is just too high and it’s going to fall eventually. I would rather wait for things to come down to get started.”
I don’t blame him for not wanted to invest everything in stocks right now, but he could invest a small portion of his money in stocks and put the other portion into other forms of investments. Keep in mind, he didn’t invest in the market when it was high in 2007, but he also didn’t invest in 2009 when it hit rock bottom.
It’s not unusual for first time investors to have this mentality
Many first time investors hesitate when it comes to investing. Personally, I spent a couple of years dreaming of investing but never took the leap of faith. What was holding me back those two years is the same thing that holds back many first time investors: loss aversion.
The loss aversion theory explains why many people are afraid to get started. People will make excuses as to why they don’t want to invest in the stock market because they are scared of losing money.
But, this begs the question, when exactly do you plan on investing in the market?
What I saw with my co-worker was a classic example of the loss aversion theory in action. He was so afraid of losing money in the market. As a result, he has not investing in the stock market at all in the past 8 years.
So you may be wondering “What exactly is the loss aversion theory?”
The theory states that people have a tendency to value gains and losses differently. So if something is presented in terms of gains and losses, people are more likely to pick the item based off the gains presentation.
Why do we value gains and losses differently?
This is due to the fact that people strongly prefer to avoid losses rather than acquiring gains of the same amount. In some studies, they have showed that the pain of losing is almost twice as strong as the pain of gaining.
In one example, people were given the option of risking $5,000 to make $10,000 on a flip of a coin. Many people would forgo the gain just so that they didn’t lose any money.
Think about that one for a second. If you could flip a coin and make $10,000 or lose $5,000, would you take that chance? Truth is, you really should take that chance. 50% of the time your will come out ahead with $10,000. What do you think you would do in this situation? Why?
How can you apply loss aversion theory to investing?
The thing about loss aversion is this: it causes people to stay in stagnant positions just so that they don’t have to risk losing any money. Due to the fact that people are so afraid of losing, they will stay in a position that is worse in the long run.
For example, some individuals would stick with losing investments over a long period of time because they don’t want to realize losses. As a result, they will ride down with a sinking ship so that they don’t have to experience the pain of losing…until it is too late of course.
To make matters worse, some people will actually invest more money into a losing stock to average out the cost of their investment. This makes it seem as though the stock hasn’t lost as much value.
How can you avoid the loss aversion bias?
Above I have illustrated two situations in investing that are subject to the loss aversion bias.
The first one being new investors who just don’t get started because they are afraid to lose money.
The second one being experienced investors who hold on to losing stock positions because they do not want to realize losses, which would turn paper losses into actual money losses.
How can new investors avoid the loss aversion bias?
For new investors, it is important to realize that there is some risk to investing in the stock market. You need to understand that your investments may lose value in the short term.
What you also need to know is that the market has been upward trending for the past 130 years and more. You can’t let your fear of losses hold you back from investing.
Another way to hedge your losses is to make sure your portfolio is well diversified. Make sure you have your money invested across a range of stock indexes, bonds, and other investment types. This will help limit your losses over the long haul and make you less likely to lose your money.
Finally, you need to stop worrying and accept the fact that you could lose money. You need to grow comfortable with the fact that your portfolio will have extremely high days and extremely lows days. The most important thing is to weather the storm and not panic on those bad days.
How can experienced investors avoid the loss aversion bias?
My advice for experienced investors is quite different from new investors. New investors are afraid of losing money from the get go whereas experienced investors are afraid of realizing losses on certain investments.
For experienced investors, you need to maintain a long term view of investments. It is important for you to understand how a loss will impact your portfolio as a whole.
One way you can avoid holding on to a losing stock for too long is to place a stop loss order on that stock. This will force you to sell your stock once it hits a certain low point.
Another good thing to remember is that selling investments at a loss will actually help you. When you sell at a loss, you will be able to offset any short term and long term taxable gains.
Final word to experienced investors
Do not hold onto a stock longer than you should. If there are legitimate, solid indications of a sign to sell your stock now, you should absolutely sell.
Now, this doesn’t mean every time a tv pundit tells you a stock is a sell that you should sell it. However, if a company is going through turmoil and revenues and profits are way down, then you should probably sell before it is too late.
You don’t want to hold on to a stock just because you hope it will go up in value. You shouldn’t buy a stock which you hope goes up in value, so why would you have that mentality for a stock you currently own?
What do you think?
What do you think about the loss aversion theory? Have there been times where you didn’t do something because you were afraid of losing? Can you apply this theory to other areas of your life?