Have you ever been going about your daily business in the shops and found yourself sucked in by a sale that brandishes the tagline: “For a limited time only!”? Have you ever been idly looking at an item online and then ended up buying it because a pop up screams there are only two left in stock? Commiserations. You may have just been snookered by a human psychological bias called loss aversion.
Loss aversion refers to the phenomenon where people are more likely to prefer avoiding a loss than acquiring equivalent gains. In other words – people tend to find losing £10 a lot more painful than, say, winning £10 on the lotto. This is what motivates people to buy something when a limited sale is on, or there are only 2 items left in stock. People don’t want to lose out and what’s more, they want to hold on to what they already have, at seemingly any cost.
This phenomenon has been demonstrated in financial studies multiple times. A notable investigation into studies of the phenomenon was performed by Kahneman and Tversky (1983) and was discussed in their paper “Choices, Values and Frames”. They analysed studies which presented questions to participants such as: “Would you rather have a sure loss of $750 OR a 75% chance to lose $1000 and a 25% chance to lose nothing?” Most people chose the option to gamble because they wanted to avoid making a loss, even though there was a very high chance that they may lose a lot more.
So how can this psychological bias affect you when it comes to investing? HITInvestments.com has a useful list of examples of where you can trip up due to this bias. Examples include: not selling a failing stock because you would make a loss, investing in safe products that are low yield and even selling an investment to avoid more losses, even though you should logically keep it.
So what can you take away from this post? The point is that you must always be mindful of what you do. When you feel the urge to buy or sell, stop and think, “Am I moving too fast?” Always look at the numbers, take a step back and take a look at the bigger picture as a whole and make sure you aren’t pressured into anything. Keep in mind as well that a sure gain may not always be the best choice and sometimes you need to take a little more risk to reap a higher reward.