Why do some investors achieve their financial goals while others don’t ? Over the last 27 years, we have witnessed many investors, who have invested in Stocks, Bonds, Mutual funds, Commodities, Currencies and other investment avenues, make money. At the same time, we have also seen some investors who lost money on their investments.
We have observed that there have been many factors that affected investors’ returns, one of the key factors that differentiated successful investors from not so successful investors has been their behavioral traits. There are several elements of the human behaviour which affect decision making while investing. These behavioural traits have key influence on whether investors’ make a profit or a loss on any investment.
One such behavioral trait that governs investment decisions is Loss Aversion.
Loss aversion refers to people’s tendency to strongly prefer avoiding losses when compared to acquiring gains. Loss aversion can be a helpful behavioral trait only to the extent that it could result in conservative behavior, however, it has a deeper negative consequence in investing, especially for investors who have an oversensitivity to loss.
Research has indicated that the reason for investors being loss averse is explained by the fact that the pain of loss is twice when compared to the satisfaction of equal gain!! i.e. a loss of Rs. 10,000 is twice as painful when compared to the satisfaction derived from a gain of Rs. 10,000. As a result, most investors try to minimize the pain rather than maximizing the satisfaction.
As losses take a psychological and emotional toll, investors make irrational decisions just to avoid the pain and end up selling the gainers and keeping the losers.
Investors exhibit risk averse behaviour when faced with gains (by locking in their profits) and risk tolerant behaviour when faced with losses (by holding on to their losing positions). In fact, when facing losses investors typically delay booking losses to defer taking the pain and some may even try to average and reduce the breakeven point rather than cutting losses.
By booking profits earlier and postponing the losses, investors also tend to increase their tax liability, although unintentionally.
With 0% tax for long term gains and 15% for short term capital gains, it is beneficial for investors to book losses within a year and book profits after an year, however, investors end up doing the opposite because of loss aversion bias.
Investors should not let short term loss become long term loss by focusing on avoiding the pain of booking a loss, thereby forgoing any tax advantage.
While investors should balance both risk and reward, they should also focus on dealing with their loss aversion bias so that they do not miss the opportunities to make attractive returns in the long term.
For example: A majority of Indians keep their money in Fixed Deposits on account of loss aversion with respect to other alternative investment options. It has been seen that over a long period of time i.e. for 10, 15 or 20 years, achieving financial goals only through investing in Fixed Deposits would not be the most feasible scenario in view of the high inflation. In the long term, investors should not have excessive focus on loss aversion alone and they should have a diversified portfolio mix where a part of the savings is also invested into various other investment avenues that produce better long term return such as Tax Free Bonds, Mutual Funds, Stocks and Real estate.