What is loss aversion?

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No one loves losing, especially when it is a financial loss. Fear of losing money can paralyze an investor, leading them to keep a failing investment long beyond what should have been sold or sell winning stocks quickly. Beginners frequently make the error of assuming stocks will recover despite all indications to the opposite because losses evoke stronger emotional reactions than gains.

The psychological pain of losing or even anticipating the potential to lose money can lead to risk-taking behavior, which can make realized losses more possible or significant. Loss aversion is a psychological phenomenon in which investors are much more concerned with avoiding losses than with gaining profits. Loss aversion develops as a person encounters more losses.

Following a comprehensive asset allocation strategy is one method to avoid psychological mistakes. Instead of aiming to predict market sentiment exactly or following the old saying to let your winners run, investors should rebalance their portfolios regularly using a rules-based system.

Another type of strategic investment is formula investing. Constant ratio strategies, for example, maintain a stable ratio between a portfolio’s aggressive and conservative sections. The portfolio is restructured regularly to maintain the desired weights—usually bonds and stocks—by selling winning assets and buying failing ones. This is in contrast to pro-cyclical momentum investment.

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Pieter Borremans
By Pieter Borremans

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