We are irrational beings. We are filled with so many biases that it’s hard to take action without being biased. And these biases can cost us a lot in personal finance.
Being bias-free sounds impossible, but being aware of them can help us avoid them to some extent. And for this, we started a new personal finance bias series to discuss various biases affecting your personal finance.
Earlier, we discussed mental accounting bias and in this post we will discuss how loss aversion bias can affect your finances.
Estimated read time: 3 minutes and 40 seconds
Buckle up, here we go!
Did you panic and sell your investments during recent market crashes? Or are you holding onto a stock that has been underperforming for months because you don’t want to realise the losses by selling it, even though other investments may offer better returns?
Or maybe you avoid investing in equity or other asset class because you fear losing money, even though it may be a good opportunity for long-term growth.
If you can relate to any of the above points, you are suffering from loss aversion bias.
What is loss aversion bias?
Loss aversion is a psychological phenomenon that describes how we tend to feel more pain from losing something than the pleasure we feel from gaining something of equal value.
The negative emotions associated with losing money are stronger than the positive emotions associated with making money. This bias is rooted in our evolutionary history, where the ability to avoid threats and losses was essential for survival.
In investing, loss aversion bias can cause us to hold on to losing investments for too long or avoid taking risks that could lead to potential losses. This bias can lead to irrational decision-making that someday harms our portfolio and wealth-building plans.
For example, imagine you brought 100 shares of a stock for ₹500 per share, for a total investment of ₹50,000. If the stock price drops to ₹450 per share, you may feel a strong aversion/repulsion to selling the stock and locking in a ₹5,000 loss.
You may hold on to the stock hoping it will recover and break even, even if better investment opportunities are available.
On the other hand, if the stock price increases to ₹550 per share, you may feel less happy than you would feel pain from a ₹5,000 loss. This bias can cause you to hold on to a stock for too long, missing out on gains or failing to take profits at the right time.
Loss aversion causes us to avoid small risks, even when they are worth it. It’s why most people save rather than invest, even though inflation will erode the value of their savings — and many investments, when held for long enough, pay off.
Sometimes it’s hard to admit we made a mistake. So we tell ourselves we will wait for our investment to bounce back. When the smarter move may be to sell and reinvest in something with better fundamentals.
In simple words, loss aversion is a bias toward avoiding losses over seeking gains. And the biggest financial mistake people make is taking too little risk, not too much risk.
How does loss aversion bias affect personal finance?
Loss aversion bias can have a significant impact on your personal finance, especially in investing. Here are some ways that this bias can affect your financial decisions:
- Holding onto losing investments: As mentioned earlier, loss aversion bias can cause you to hold on to lose making investments for too long. This can lead to significant losses that could have been avoided if you had cut your losses and moved on to other opportunities.
- Avoiding taking risks: Loss aversion bias can also cause you to avoid taking risks that could lead to potential losses. For example, you may avoid investing in equity because you are afraid of losing money.
- Overreacting to losses: You may overreact to your loss, leading to panic selling and further losses. This can create a vicious cycle where your emotions lead to poor decision-making and ultimately hurt your portfolio and financial goals.
- Failing to diversify: Loss aversion bias can also cause you to put too much emphasis on a single investment or asset class, leading to a lack of diversification. This can increase the risk of significant losses if the investment or asset class underperforms.
- Missing out on gains: Finally, you may miss out on gains by holding onto winning investments for too long. This can lead to missed opportunities and lower returns over the long term.
How to overcome loss aversion bias?
There are some strategies to overcome loss aversion bias to some extent and to make better investment decisions.
- Set clear investment goals: Setting clear investment goals can help you stay focused on your long-term objectives and avoid deciding based on short-term emotions.
- Diversify your portfolio: Diversification is a key strategy for reducing risk and avoiding overreliance on a single investment or asset class.
- Be more systematic: While taking investment decisions, be more systematic. Take decisions based on numbers and facts. Don’t rely too much on emotions. Build systems which help you avoid being biased.
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