Losing Loss Aversion

By Craig Basinger, CFA & Shane Obata

 

You own 1,000 shares each of company A and B, each originally purchased for $100. Since buying, company A has declined to $80 and company B has risen to $120. If you need to raise some cash then which one do you sell? If you said sell stock B then you may suffer from loss aversion. This behavioral bias often elicits itself in the form of investors selling winners and holding onto losers in their portfolios. There are a number of factors that contribute to this behavior and it is one of the more prevalent behavioral pitfalls for investors. Many studies have indicated that selling winners and holding losers detracts from long term performance.

Despite the wide body of supporting research, we decided to get our hands dirty in the data. We took the TSX 60 over the past 15 years, comparing the subsequent annual performance of the best performing decile to the worse performing decile. The best performers are the winners and the worst performers are the losers. The only periods in which this trend reversed were during low-quality rallies that often occurred following bear markets. But it was certainly the exception, as winners dominate in most years. Similar results were found in the U.S. market as well.

 

 

 

What Causes Loss Aversion

There are a few factors that contribute to loss aversion. The first is losses hurt more than gains feel good. There is an asymmetry between gains and losses. In other words , a $20 loss has a greater negative feeling than the positive feeling of a $20 gain. Would you play a coin toss game if heads you win $100 and tails you lose $100?

Probably not. But what if heads you win $120? Chances are you would still not play as most studies found that you need $150 to $200 on a winning toss to compensate mentally for the equal chance of losing $100. The size of the winning coin toss required to offset the $100 loss may indicate your level of loss aversion.

 

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Charts are sourced to Bloomberg unless otherwise noted.

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