What Investors Can Learn From Prospect Theory Or The Loss Aversion | My Money Sage
Heard about that investor who hates losses? Well, almost all investors hate to make losses on their investments. Most of us feel twice the pain when we make a loss on an investment than when we make a gain. This is known as loss aversion bias.
This is a behavioral trait which says that losses and gains are valued differently. So, individuals are more likely to make decisions based on perceived gains rather than perceived losses. It says that if two choices are put before an individual, both equal, with one being potential gains and the other being possible losses, the former option will be chosen.
The Loss Aversion or the Prospect theory was formulated in 1979. However,it was further developed in 1992 by Amos Tversky and Daniel Kahneman. Research done by these Israeli-born psychologists on cognitive biases and bounded rationality was path breaking. Kahneman had won the Nobel prize in 2002 for the work on Prospect Theory.
Tversky and Kahneman proposed that losses cause a greater emotional impact on an individual than does an equivalent amount of gain.
For instance, let us say you will be receiving Rs. 25,000. One option is you are given Rs. 25,000 right away. The other option is you gain Rs. 50,000 and you will loseRs. 25,000. You are getting the same amount of money in both the options. However, you might be likely to choose to receive straight cash because a single gain is seemingly more favorable than initially having cash and then suffering a loss.
This behavior pattern is seen in investors too. For investors, loss aversion is a behavioral pattern where instead of cutting their losses, investors are reluctant to sell an investment when it is making great losses. Investors are eager to sell investments that are doing extremely well. This is to book profits to make money.
Not convinced? Another example will help you. Let’s say a financial advisor recommends a mutual fund to an investor. He says that the fund’s average return is 16% over the past three years. Then, another advisor recommends the same fund but says that the fund has provided above-average returns for more than a decade but the one-year return is low. According to the Prospect theory, though the investor was provided with the same mutual fund, he is more likely to buy the fund from the first advisor, who said that the fund’s rate of return has been good.
How does loss aversion affect investors?
The first thing that loss averse investors lose out on is higher returns. How? There are individuals in India who think that the stock market is for gamblers. Eve investors who are younger than 40 years think that the equity markets are risky.This is a justification given by them as to why they prefer the safety of bank deposits, government schemes and guaranteed return investments such as post-office deposits and public provident fund. So, loss aversion or the fear of losing one’s capital keeps individuals away from equities. This will affect their portfolio returns in the long run. If they do not choose investments that help beat inflation, their real returns (gains minus the inflation rate) will be low.
Another point is that loss aversion makes investors disregard their asset allocation. Typically, the younger you are, the more risks you can afford to take if you need to have a reasonable amount of money by your retirement. Loss aversion could mean a skewed asset allocation. Investors who need to invest in equities, fixed-income investments and gold might invest in only bank fixed deposits and government schemes. They will not even be able to increase their wealth in a decade, let alone make profits and create a good fund for their financial goals.
Another mistake that loss averse investors make is that they are reluctant to sell a losing stock. This could be their inability to accept that they have made a wrong investment. So, typically investors wait for the stock to get back up to the price at which the investor bought it. This may or may not happen. If the investor waits and waits, the stock price could reduce further. If it is a fundamentally sound stock, it might increase. If the investor waits for too long to exit a losing investment or spends more money to buy the stock to recover losses, then the investor is loss averse. This behavior will adversely affect all his investments. While he is waiting or pouring in more money into a losing stock, there might be other stocks that could provide higher returns. So, loss aversion could result in wasted time and efforts by the investor.
What should you do?
Often investors let their emotional quotient take over their intelligence quotient. This could be avoided. Understand that you need to have a rationale when you invest. It is important to set aside your emotions and look at the investments from the eyes of a potential investor. This will help you look at whether the investment is worth holding on to or worth selling. You should cultivate an ability to take losses in your stride and try to ensure that you do not repeat your investment mistakes. You should also know when to add more money to investments that are likely to do well in the long run.
Another point is that with job losses and the economic slowdown, you might need to invest more to make more money. The better the investments, the more income and wealth you can make in the long run. Every investor needs to make decent inflation-adjusted returns on his savings. That is why you cannot let loss aversion prevent you from investing in the equity markets. If you do not want to take high risks by investing in stocks, stick to mutual funds.
The participation in mutual funds is much more than what it was before. The Assets Under Management (AUM) of mutual fund Systematic Investment Plans (SIP) crossed Rs. 3 trillion in October 2019. This is a year-on-year increase of 18 per cent. As per data provided by the Reserve Bank of India (RBI), the share of currency and deposits holding in Indian households reduced from 55 percent in FY16 to 51 percent in FY18. Another point that the data revealed is that the share of equity in the Indian household savings increased from 3 percent in FY16 to 8 percent in FY18.More people in India are investing in equities reducing their deposit investments So,investors seem to be putting the loss aversion effect behind. It may not be wrong to assume that there is a shift at play in India as traditional savers try to overcome their loss-aversion mindset and start investing in equities as an asset class for wealth creation.
In conclusion, we could say that while behavioral theory such as the loss aversion theory helps us to understand the rationality behind an investor’s actions, it is up to each of us to manage our loss-aversion bias. You should not allow the loss aversion effect to affect your portfolio investments or the returns. If you find it tough to take investment calls, it is good to consult a financial advisor who can help you make the right investments based on your finances, risk profile and goals. You need to just rely on their decisions to ensure that you are able to make sufficient wealth in the long run.