Why are investors psychologically uncomfortable with booking losses?
Loss Aversion Bias: “Holding on to the loser but getting rid of the winners”.
The traditional financial theory is based on the premise that investors act rationally and analyse all relevant information while making financial decisions.
The reality is far from being true. Contrary to this belief, individuals may follow more subjective, sub-optimal and biased financial decisions.
Let us discuss, one of the most common behavioural biases of investors - Loss Aversion Bias.
Simply put, the tendency to avoid losses is what drives the majority of investment decisions. Based on the premises that the Utility derived from a GAIN is less than the Utility given up with an equivalent LOSS.
Driven by this tendency, investors hold on to investments that have experienced losses (losers) for too long but are quick to sell investments that have experienced gains(winners).
“Holding on to the loser but getting rid of the winners”.
What are the consequences?
An investor is essentially limiting the upside potential of his portfolio by selling winners and holding on to losers.
Selling an investment at a slight glimpse of profit leads to excessive trading hence increasing the overall cost of the portfolio.
Holding riskier portfolios is acceptable based on his risk/return profile.
How loss aversion bias is mitigated?
The virtues of a disciplined approach to investment based on fundamental analysis cannot be overemphasized.
Review of the portfolio performance over at least two years to identify the winners from the losers. Investors are expected to be objective when making and evaluating investment decisions.
Practise of stop-loss mechanism in all the scrips in the portfolio so that as and when it is triggered, as a practise the scrip is exited. The loss booked in the process may turn out to be much less compared to the situation it is left unattended.