S2.E3: Behavioral Insights into Investing - Loss Aversion

Why can losing $20 feel more powerful than gaining $20? In this episode of Behavioral Insights into Investing, we explore loss aversion, the disposition effect, and why investors may hold losing investments while selling winners too soon. We also look at how reference points, frequent portfolio checking, and emotion can shape investment decisions.

This episode is for educational and awareness purposes only and is not investing advice.

Research mentioned:

Kahneman and Tversky, “Prospect Theory: An Analysis of Decision Under Risk”
https://web.mit.edu/curhan/www/docs/Articles/15341_Readings/Behavioral_Decision_Theory/Kahneman_Tversky_1979_Prospect_theory.pdf

Terrance Odean, “Are Investors Reluctant to Realize Their Losses?”
https://faculty.haas.berkeley.edu/odean/Papers%20current%20versions/AreInvestorsReluctant.pdf

Shlomo Benartzi and Richard Thaler, “Myopic Loss Aversion and the Equity Premium Puzzle”
https://www.nber.org/system/files/working_papers/w4369/w4369.pdf

Transcript

Intro

SPEAKER_00 0:14

Hey everyone! Welcome to My Two Cents. I'm your host, Mahima, and this is Behavioral Insights into Investing, a series about the hidden habits and emotions that can influence what we do with money. Before we begin, a quick note. This episode is for educational and awareness purposes only. It is not investing advice and it is not telling you what to buy, sell, or trade. The goal is to simply understand how our minds can influence financial decisions. With that, let's jump into today's bias, loss aversion.

What is Loss Aversion

SPEAKER_00 0:52

Loss aversion is the tendency to feel the pain of losing something much more strongly than the pleasure of gaining something of similar value. Think about finding $20. That would probably feel pretty good. Now imagine realizing you lost $20 earlier that same day. For many people, the loss is harder to forget. Psychologists Daniel Kahnman and Amos Tversky explored this idea through prospect theory. Their research suggested that people do not always judge financial outcomes from a neutral starting point. They compare them with a reference point, such as what they paid, what they expected, and what they had before. And that reference point can become important. If our investment falls below the price we paid, selling it can feel like turning a temporary drop into an official loss. Holding it leaves open the possibility that it may recover.

The Disposition Effect

SPEAKER_00 2:02

In investing, loss aversion is often connected to something called the disposition effect. This is the tendency to sell investments that have gone up while continuing to hold on to investments that have gone down. Economist Terence O'Din found this pattern while studying trading records from thousands of brokerage accounts. Let's say we have a person named Maya. Maya buys shares in two companies after doing some research. Company A rises by 20%, while Company B falls by 20%. Maya sells Company A. Locking in the gain feels satisfying. But she keeps Company B because selling it would mean accepting the loss. Few months down the line, Company A still does well, but Company B is starting to become weaker and weaker. Of course, selling a winner is not automatically a mistake, and an investment that falls can still recover. The interesting part is what influenced Maya's choices. She was paying close attention to the prices she originally paid and to how each decision would feel. The original purchase price had become her main reference point, even though it did not necessarily say much about what either company would do next. Over time, this pattern can affect a portfolio in a few ways. Money may stay invested in a company even after the original reason for owning the investment may have changed. Loss aversion can become especially noticeable when markets move quickly. During a sharp decline, one person may sell because they want the discomfort to stop. Someone else may avoid selling anything because accepting the loss would feel worse than continuing to wait. Those reactions may seem completely different, but really the same emotion can sit behind both of them. Loss

Keeping Losses in Perspective

SPEAKER_00 4:13

aversion is not something people can simply switch off. Even experienced investors can feel a strong reaction when an investment drops. What helps is creating a little distance between the feeling and the decision. Some investors write down why they bought something in the first place, reasons for what they liked, what risks they saw, or what might change their mind in the future. Later, when the price falls, they can look back at their reasoning instead of relying on how they felt in the moment. One useful question to keep in mind is if I did not already own this investment, would I buy it today? This framing helps move the focus away from the original purchase price and back to the investment itself and the reasoning behind it. Checking a portfolio less often can also change the overall experience. Research on myopic loss aversion suggests that seeing losses more frequently can make them feel more important than they really are over a longer period of time. Some people also review their portfolios on a set schedule or rebalance them back to a planned mix of investments. That can make the process feel less like reacting to one bad day. And then there is always the value of looking back. A decision log can help show whether the original reasoning made sense, even if the result was disappointing.

Closing

SPEAKER_00 5:51

To wrap up, loss aversion is one reason a small loss can take so much mental space, while an equally sized gain feels much less memorable. In investing, that feeling can influence what people sell, how long they hold an investment, and how they interpret their own decisions. The next time an investment falls, it may be interesting to notice which part feels the most uncomfortable. Is it the change in future prospects, or is it simply the fact that it is now below the price that was originally paid? The point is to make a decision based on what you know now, rather than on how much the loss hurts. This has been my two cents behavioral insights into investing. Thank you for listening.