Macro Minute: Week of July 17, 2023
Today, I would like to discuss another behavioral bias that affects us as investors, leading to less than desired outcomes. Daniel Kahneman and Amos Tversky introduced Prospect Theory, also known as loss aversion. What they observed is that people feel losses about twice as much as they do gains.
This causes some quirky human behaviors. In sports you have probably heard it said, “I like to win, but I hate to lose.” Because we perceive losing as hurting much more than winning feels good, we act in ways that does not lead to the highest payout outcomes. We can be offered two identical payout and loss potential options. Option one is presented in a way that highlights the potential loss and option two is presented in a way that highlights the potential gains. The vast majority of participants will choose option two even though there is no difference.
Another thing this leads people to do is to hang on to losers much longer than they should. Let’s say that you buy a stock and it goes down and the investment no longer has the prospect of generating returns in the future, people will hang on to that stock to keep from realizing that loss. If that person was given the same amount of money as the value of the stock, very few people would buy the stock anew. These behaviors do not usually result in the best outcomes, but we continue to repeat them because we don’t like to feel loss.
To overcome this bias, it is crucial to establish a well-defined plan for your investments. Avoid making impulsive decisions driven by emotions and instead stick to your plan. Take a step back and ask yourself, “If all else were equal, would I still choose to make this investment?” Furthermore, seeking guidance from a knowledgeable professional can provide you with a fresh perspective and assist in making informed decisions. By recognizing and addressing this bias, we can enhance our investment strategies and increase the likelihood of achieving more favorable outcomes.
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