Loss aversion bias. Your risk appetite is around 2:1.

Loss aversion bias is a behavioural pattern where a person is more inclined to avoid losses than enjoy gains. This emotional bias is difficult to overcome and requires permanent discipline and control. An investor with a loss aversion bias would prefer to keep an unprofitable investment, leading to poor investment results and suboptimal asset allocation. You can discover whether you are prone to overconfidence bias and the extent to which it affects your investment decisions with PRAAMS BehaviouRisk.

Behavioural economics. What is loss aversion bias?

This is an emotional behavioural pattern whereby a person is more inclined to avoid losses than to enjoy gains. Scientists have found that a person, on average, will accept the risk of losing $1 only if offered the opportunity to gain at least $2 in return (demonstrating risk aversion). The gain-loss ratio is 2 to 1; i.e. a person, on average, desires higher gain vs risk.

What are the consequences and investment risks?  

The implication in investment decisions is quite simple: an investor with loss aversion bias would prefer to keep an unprofitable investment than sell it and rebalance the portfolio. The desire to avoid losses motivates the investor to wait until the investment’s price recovers – even though it may never happen. Typical justifications used by such investors include: “it will go up again”, “it is just a paper loss”, “it becomes a loss only when I sell it, and before that, I still have a chance to break even on this investment”, and many others. Similarly, many investors with strong loss aversion bias tend to fix profits as soon as they appear, thus limiting potential upside and engaging in more frequent trading strategies. 

A combination of holding unprofitable investments for too long (‘keep the losers’) and quick profit fixing on profitable investments (‘sell the winners’) leads to poor investment results and suboptimal asset allocation. Over a longer period, loss aversion bias degrades the risk-return relationship in a portfolio. This is especially dangerous for long-term investing. The negative effect of loss aversion worsens for investors who rebalance their portfolios more frequently. In this case, these investors will hold more ‘losers’ and sell ‘winners’ with smaller gains. 

What can I do to make my portfolio more efficient?

The most important practical advice for overcoming loss aversion bias is the use of stop losses as a part of a risk management strategy. It is wise to set these when an investment is made and agree to execute them when triggered, which requires self-discipline. As with any pre-determined rule, one must consider the nuances of the particular asset beforehand. 

For example, if the regular volatility of an asset is high, for example, a typical asset-price swing is from -20% to +20%, the stop loss should be wider than -20%. However, if the asset has low regular volatility (for example, from -5% to +5%), then a 7-10% stop loss may be ok, depending on one’s risk tolerance. Remember that the stop losses help to overcome loss aversion bias and many other negative investing patterns. 

The same is valid for taking profits. One may want to set a take-profit level when an investment decision is made and execute it when the time comes, which again requires discipline. As with losses, individual characteristics should also be considered to avoid the early sale of ‘winners’. 

Finally, one should always remember the importance of diversification, which usually suffers when an investor has a severe loss aversion bias.