LOSS AVERSION
The effects of framing can be explained by human beings’ aversion to loss. There have actually been some studies which suggest that losses can be as much as twice as psychologically powerful as gains. And from an evolutionary psychology perspective, this makes a great deal of sense when you think about it. If you only have $1000, making $1000 would give you $2000, but losing $1000 would wipe you out entirely. And given the human need for money to procure food and shelter, it is far more motivating to avoid losing that $1000 than it is to make that $1000. So how does all this relate to the world of investing?
The aversion to loss is so great with most investors that the thought of selling a stock when one is down (showing a paper loss) is truly abhorrent and too painful to face. Many investors hang on to losing stocks in the hope that one day, the stock will come good. They do so even when there is no information to suggest this recovery will occur. In other words, their distaste for losses renders them unable to make a sound investment decision when losing money and they start to gamble.
But refusing to sell a stock when it is down (unless there is a good reason to hold) is akin to a failure to acknowledge reality. Many investors continue to hold loss-making stocks in the hope they will one day recover. Take the loss (good for your tax return!), move on and get your money working for you again. The reality is that investing must be based on logic and rational decision- making, not hope and blind optimism.
The moral of the story here is to never let your distaste for losses cloud your investing judgment. Losses hurt, but don’t hide from reality… accept the loss and move on. Don’t let your decision-making be compromised. And you’ll be surprised how much better you feel once you finally take that loss and move on. It’s a weight off your shoulders… just because you hadn’t sold before doesn’t mean that the as yet unrealised loss didn’t bother you. It probably bothered you on a daily basis, keeping you awake at night.
The fact is that every single investor in the world will make mistakes and be faced with the need to take losses at some point. If this decision cannot be made quickly and without emotion, it is only a matter of time before an investor ends up with a portfolio full of loss making failures, as they are the only investments they refuse to sell.
Far and away the most famous and successful stock market investor of all time.