When it comes to making investment decisions, often we are not able to make optimal decisions despite having the relevant knowledge and information. This is primarily because of human biases that can colour our judgment and impede our ability to make the right choices. We are all aware that all investments carry a certain level of risk. Some investments are riskier than others and knowing this is important while building your investment portfolio.
When it comes to risk, or encountering a dangerous situation, most of the people have one of the two responses – fight or flight. In the investment world, the response that most investors have to heightened risk is “flight”. This reaction stems from the loss aversion bias.
Loss aversion is the tendency of investors to become so fearful of making a loss that they focus more on trying to avoid a loss than on making gains. Interestingly, as an investor experiences loss, this bias only escalates further with the investor becoming more and more prone to lose aversion. According to research, investors are twice as likely to feel the pain of loss as they are likely to enjoy making a profit.
If your answer to any of the below questions is a “yes” then you are more than likely suffering from a loss aversion bias.
Do you quickly sell the winner without the investment realising its full potential while continuing to hold on to losers in the hope that the investment will eventually turn a profit?
Do you avoid selling a stock even though your current rational analysis of the stock clearly indicates that you should exit the investment?
Do you sell a stock as soon as it has witnessed marginal gains even though your analysis indicates that the stock should be held for much larger gains?
Do you only invest in low-return, guaranteed investments over more promising investments that carry higher risk, even though your risk profile allows you to absorb a higher level of risk?
Do you often tell yourself that an investment is not a loss until it is realised?
Now that we know the problem, let us see if we can find a solution. The most important thing is to adopt a portfolio perspective and avoid looking at your investments in silos. It is often noticed that while one investment is underperforming, others are performing well, thereby, maintaining the overall portfolio objective. From this perspective, building a diversified portfolio that is spread across asset classes, can help minimise the portfolio volatility and therefore, hedge the portfolio from extreme losses. Additionally, it is predominant to remain consciously aware of loss aversion as a potential weakness in your investing decisions.