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The pain of losing $100 is far greater than the joy gained in winning $100

Will you ever take part in a bet where you lose $100 for every tail that comes up in a coin toss and gain $100 for every head that comes up?


Probably no, I guess.


What if the stakes is such that you still lose $100 for every tail that comes up but instead win $200 for every head?


You will probably agree to it.


This is what we called loss aversion. The first scenario is an entirely fair one. However, most people will not like the odds of it because the pain of losing something is usually far greater than the joy gained in winning something in equivalent value. The potential gain needs to be much higher to offset the pain of losing and hence most people will agree to the bets in the second scenario.


I recently ran a poll of similar nature in my Telegram Group.



Most people choose option 2.


This is a bit strange because you actually have more to lose by choosing option 2. The Expected Value of loss in Option 2 is $3200 (0.8 multiples by 4000 plus 0.2 multiples by 0) which is larger than $3000 (Option 1). However, most people will end up choosing option 2 as they have the impression that there is a very small chance of losing nothing. This is loss aversion at play.


Now, let's change the question a little bit and see how the responses are.



Most people now choose Option 1. Again, the better option to choose from a mathematics point of view is Option 2 as the Expected Value of Gain is $3200 which is larger than $3000 (Option 1). However, there is a slight chance that you will win nothing in Option 2 which most people will try to avoid.


So, how do all these matters in investing? A reader asked me this question.


My personal opinion is that the loss aversion mentality is evident in investing too. Very often, we do not abandon our losing position and cut losses immediately as it is a definite loss if we do so. We tend to hold on to the position in hope that the stock will eventually recover. More often than not, the stock might continue to dive and result in a greater loss. If you need an example, just think of Alibaba. In hindsight, I'm sure most people would rather cut their losses three years ago than to hold on to the position for the past 3 years when it is on a constant decline. I am unfortunately one of them.



So how do we avoid loss aversion in investing?


One way is to ensure that we adopt a systematic approach by predefining target allocations for each of the constituents in our portfolio and only rebalance it annually. Rebalancing too often will disrupt your winning position. Have a predefined target allocation (eg. 50% SPY 50% Bitcoin). At the end of every year, look at what is their new allocation level and determine what's your desired allocation level. If you have the opinion that you want to reduce your exposure risk towards one of the constituents, you can adjust the target allocation downwards and rebalance it accordingly. Example, if the new allocation after a year of market performance is now 40% SPY and 60% Bitcoin, and your new target allocation level of 60% SPY and 40% Bitcoin (to reduce exposure towards Bitcoin), you can rebalance your portfolio accordingly. This could help you remove emotions in play and have a factual approach in maintaining, adding, or reducing positions in your portfolio. The difficult part of this approach is to determine what is the appropriate allocation level for each of the constituents in your portfolio. I once wrote an article on Seedly about this and you might want to check it out.


Interested in participating in polls that were shared in this article? Join my Telegram channel. 210+ like-minded investors have already joined this channel. What are you waiting for?

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4 Comments


Chess game99
Chess game99
Oct 29, 2023

Hi,


Saw your posted reply on my comment on this scenario you are posting. Thanks. So i thought i will reply but post it in the correct post. I view the 2 scenarios you are sharing has 2 idea ie


  1. Loss adversion especially if the loss adversion to the intial capital

  2. Profit potential.


And my approach to handle these 2 ideas is that ne needs to know if the capital should capital protected or capital at risk.


If we apply this capital consideration :


For the scenarios where you have option 1 as a sure gain and option 2 with a higher gain and certain probability of loss :


With the intial seed funding or capital for a portfolio, …


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Thanks for your insights! These are great thoughts and certainly excellent material for consideration. Appreciate you sharing your opinions. It benefits me and certainly benefits the readers too!

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Daniel Yeo
Daniel Yeo
Oct 28, 2023

We are always wiser on hindsight.


How do we know there's 80% chance of winning something and 20% of winning nothing is a mystery and no one can be perfectly sure about this.


Cut our losses and protect what we have is what we we must diligently stick to.


My personal view is that investment is not for everyone. Most retail investors lose money. Even big hedge funds lose money because there are just too many variables as well as unforeseen circumstances to determine that probability. Insiders are usually the ones making money quietly. They love that you participate in the market.


For retail investors, I can see why they would rather go for 100% chance of winning a lower…

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Thanks for sharing!


Indeed, there are many variables and unforeseen circumstance to determine with certainty any probability in the world of investing. Not to also forget, we have not even taken into context the repeatability element which might manifest itself in sequence of returns risk that has a real impact on how our portfolio will perform over a period of time.


This is probably also why a lower return investment strategy with much lesser volatility (or beta) could be preferred by many when taking a long term horizon approach.

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