Loss aversion bias in trading

loss aversion

Biases in trading refer to the cognitive and emotional tendencies that can lead traders to deviate from rational decision-making and potentially affect their investment outcomes.

These biases can influence how traders perceive and interpret market information, how they make trading decisions, and how they manage risk. loss aversion is one of them.

In simple words, human behaviors can have a negative impact on our trading activities.

Clearly, before being vigilant about something, it is essential to have knowledge about it.

Once you acquire this understanding, you will recognize that you possess certain behaviors that lack logical reasoning, enabling you to initiate a process of personal transformation.

Loss aversion holds the utmost significance among these biases.

What is loss aversion?

The theory posits that losses have a more significant negative impact compared to the positive impact of equivalent gains.

The negative impact is approximately twice as significant as the positive impact.

What’s that mean? Let’s play a game

Heads or Tails for $10000, Would you be willing to participate in the game with me? Most likely, you would decline.

Due to the fact that there is an equal probability of making or losing money, and the amounts are identical, it is essentially a zero-sum game.

However, you may perceive the potential loss of $10,000 as significantly more distressing than the possibility of gaining the same amount.

So we do not perceive losses and gains as equivalent; we tend to perceive losses of an equivalent amount as far more detrimental than acquiring the same amount.

In Decision Theory, Loss aversion refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains.

It’s better to not lose $10 than to find $10.

These biases are widely recognized and extensively studied in the fields of economics and decision theory, making them highly significant.

We are transcending the simplistic greed and fear model commonly taught in many trading courses, as there exist specific biases that can be identified and actively modified.

Research about loss aversion

A research team endeavored to provide evidence supporting the existence of loss aversion, demonstrating that we indeed perceive losses as significantly more unfavorable than equivalent gains.

Their realization was that loss aversion is consistently dependent on a reference point, always influenced by one’s current circumstances or position.

Their approach involved selecting a group of individuals and informing them that they currently held a job where their level of interaction with others was somewhat isolated, and their commuting time averaged around 10 minutes.

Now, they presented two distinct options for new job choices to the participants.

JOB A entails a degree of limited interaction with others (superior to the current job), yet it necessitates a commute time of 20 minutes.

On the other hand, JOB B offers a moderately social environment (better than the current job and JOB A), but it requires a long commute time of 60 minutes.

It is highly probable that you would prefer JOB A, just like the majority of individuals in the group.

However, this outcome does not provide conclusive evidence. Therefore, to further investigate, they introduced a different reference point, shifting from the current job as the reference point that participants were using to make their choice.

Imagine a scenario where your current job is not isolated, but rather highly social, with an 80-minute commute time.

Now, given this new perspective, which job offer would you choose?

In both scenarios, you would be sacrificing contact with people, but in terms of commute time, you would be gaining (reducing your commute time).

What they discovered was that people preferred JOB B. In other words, they were inclined to transition from an environment with high social interaction and an 80-minute commute time to a setting that offered social interaction with a 60-minute commute time.

They were unwilling to opt for something that involved extremely limited contact with people.

Despite the fact that both jobs involved the same type of work, people still made a distinct choice based on where they started or reference point. The question is, why?

Essentially, their decision was influenced by their focus on what they stood to lose. The determining factor for their job choice was primarily based on the specific aspect they perceived as a loss.

In the initial scenario where the current job was an isolated environment with a 10-minute commute time, their decision-making process for choosing JOB A did not revolve around the potential for improved social interaction. Instead, their primary concern was the loss of commute time. Because in both Jobs they were losing on commute time.

Their intention was to minimize their losses, leading them to opt for the job where they would experience the least amount of loss.

The significance of what is lost outweighs the significance of what is gained.

When the scene shifted to a highly social environment with an 80-minute commute time, their focus was not on the reduction of commute time from 80 minutes to 20 minutes. Surprisingly, they disregarded the commute time altogether and instead prioritized the level of contact with people, as that was the aspect they perceived as a loss in both job options.

Their preference leaned towards transitioning from a highly social environment to a moderately social one, rather than opting for a limited social setting.

Therefore, their decision-making process was primarily influenced by the aspects they perceived as losses.

That is why heartbreaks cause more pain than the joy of finding love.😂

How loss aversion affects trading?

Given that you currently hold 1000 shares in a company you purchased at its peak, and the stock price is declining, I advise you that it appears to be a disadvantageous position and recommend reducing your risk by selling the shares.

However, you are likely hesitant to sell due to your belief that the price will rise or other reasons. In this scenario, if I suggest buying another 1000 shares, you are also likely to decline the offer.

Why is it not considered a favorable position, as you previously mentioned?

There is a constant fear of incurring losses or taking on additional risks beyond what you are already exposed to.

The fear of experiencing the worst-case scenario and the accompanying feelings of regret and self-blame weigh heavily on you. The anticipation of these emotions is highly discomforting to the extent that you strive to avoid them altogether.

Let’s consider a scenario where an individual purchases a stock at $10, and it subsequently rises to $20 before dropping back down to $15.

Assuming an initial investment of $10,000, when the stock reaches the $20 mark, they experience a gain of $10,000.

However, when the stock drops to $15, their gain diminishes to $5,000. In both situations, they are still making a profit.

However, when they decide to close their position at $15, taking a $5,000 profit, they find themselves discontented.

This is because their reference point now becomes $20, where the stock was valued at one point. Consequently, they perceive it as a loss of $5,000, despite having made $5,000 in profit.

Occasionally, individuals experience dissatisfaction and refrain from taking their profits because the pain or negative emotions associated with not selling at the peak outweigh their desire to secure the gains.

It is important to understand that losses tend to appear larger and feel significantly worse than equivalent gains, but this is merely a human bias that affects us all. If you allow these emotions to dictate your trading decisions, you will likely struggle to make sound trades because you will deviate from the mathematically correct approach.

Moreover, wins may not appear as substantial as they actually are, leading to detrimental consequences for your trading. This can result in an inclination to take larger or riskier trades in an attempt to compensate for previous losses.

That could be a major problem in risk management, and taking your losses and not taking your losses.

Here is the Research Papers.