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.
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