What is Loss Aversion Fallacy?

Sometimes it’s good to lose

Many investors have thought to themselves; “if I never realise a paper loss I never really lose, I’ll just wait until the market improves and then sell my shares/fund/house”- not so fast, if you’ve ever caught yourself thinking this you may have fallen victim to what’s known as the ‘Loss Aversion Fallacy’.

About Loss Aversion Fallacy

Predicting the future is extremely difficult, even the best investors get it wrong all the time, but how you react to a loss makes all the difference.

Everyone is subject to cognitive biases, the key is recognising this, only then can you minimize the negative effects and achieve more optimal outcomes. Loss aversion fallacy is one of the more common biases which plague investors.

The fallacy was first identified by behavioural psychologists and is known to be an innate human tendency. Like most human tendencies it’s probably more good than bad, and in most contexts very helpful. It becomes a problem in investing when your preference for avoiding a loss becomes the very reason you hold an investment.

Here’s an Example

If an investment loses $10,000 in value it’s natural to want to recover that loss. However, whether the very same investment recovers its $10,000 loss or a completely different investment gains $10,000 makes no difference, all else being equal.

So next time one of your investments performs poorly the real question you should be asking yourself is; ‘is this the optimal investment, is this what I would invest in if I were starting again from scratch?’ If the answer is yes, the investment may still hold all the characteristics that made it a good investment in the first place – in which case it could even be a good time to add to your investment. Just make sure you are not holding it to avoid ‘losing’. There is no shame in cutting your losses.

As economist John Maynard Keynes said ‘when the facts change, I change my mind’. If you keep this in mind will hold you in good stead, after all you are not the captain of a ship, so there is no sense in going down with the ship.


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