No One Likes A Loser: The Impact of Loss Aversion on Investment Decision-Making
Suppose I offered you the chance to win $50 on the flip of a coin. If the coin lands heads, you win! I pay you $50. But, if the coin lands tails, you will have to pay me $50. Would you take the bet? Researchers in the field known as behavioral economics have posed questions like this to study participants, determining that most would not take that bet. But consider the fact that, with even odds and equal payouts and losses, people should be indifferent to playing the game. What if you stood to win $75? You still will have to pay me $50 if the coin lands tails, but your payout is larger if you win. If we repeated the game, odds are in your favor to make money over time. Again, researchers find that most people are still not willing to take that bet. In fact, they find that the payout needs to be at least twice the loss before people take such a bet. Researchers refer to this behavior of avoiding losses, rather than seeking equivalent gains, as “loss aversion.”
The concept of loss aversion was first proposed by psychologists Daniel Kahneman and Amos Tversky in 1979 as part of their “prospect theory,” which characterized decision making through the lens of whether people were facing the prospect of either gains or losses. Kahneman and Tversky observed that people place a premium on avoiding losses – in their words, “losses loom large” – but also noted that people are more likely to take risks when starting with a loss than with a gain. In their words, while investors may be “risk-averse” if starting with gains, they are actually “risk-seeking” if starting with losses.
For investors, loss aversion can influence decision making in two notable ways: holding on to losing positions for too long and avoiding taxes on capital gains for appreciated positions.
Loss aversion can lead investors to continue holding on to positions with unrealized losses. The theory is that actually realizing losses is painful, but also that investors are more willing to bear the ongoing risk of loss, or overall lagging returns, simply for the chance to recoup at least some of those embedded losses. As Kahneman and Tversky suggest, they are “risk-seeking.” If the investment’s underlying fundamentals actually support a recovery, this may be a worthwhile bet. But also consider the math behind that move. An investment that has lost 20% needs to gain 25% just to break even. Depending on the investment, investors may have reason to believe their investment can outperform as needed, but they should also know that loss aversion may be inflating their appetite for risk. We try and frame the conversation around harvesting losses around the possibility of using these losses to help offset gains that we may want to take in the interest of repositioning the portfolio. In this sense, investors may view the embedded losses as a means of tax savings, which can help to address the other way that loss aversion impacts investors.
Loss aversion can also deter investors from selling positions with unrealized gains, due to tax implications of the sale. While most investors realize that selling for a gain is a good thing, many consider the taxes due on the sale as a loss. Since “losses loom large,” many investors forego the sale to avoid paying the tax on gains. In some cases, the underlying holding is providing some ongoing benefit to the portfolio. But often, positions with significant unrealized gains are also concentrated holdings that expose the portfolio to undue company-specific and sector risks. No investor enjoys paying taxes, but avoiding the “loss” from taxes generally should not deter investors from reducing risk in their portfolio, when it is appropriate. In the dot com era, many clients became wealthy holding concentrated stock positions, due to stock options and super high valuations based on nothing but “irrational exuberance.” We have also seen the flip side of highly concentrated stock positions, as a number of these company stocks lost much, if not all, of their value in the 2000 stock market crash and subsequent recession. The goal is to not let the perceived “loss” from paying capital gains tax keep you from making a rational decision that may help reduce actual portfolio losses.
Given the negative impact loss aversion can have on their behavior, is there anything investors can do to mitigate its effects? In fact there is! Research has shown that simply informing investors of these biases can empower them to avoid many of the most destructive behaviors. So, the next time you’re hesitant to sell a nonperforming portfolio holding at a loss, or are stymied by the prospect of paying capital gains taxes, consider the influence loss aversion may be having on your decision.
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Information contained herein was derived from third party sources including, but not limited to, Bloomberg, Standard & Poor’s, Dow Jones & Company, the Federal Reserve Bank of New York, and Morningstar, Inc. While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any information presented. We have not and will not independently verify this information. Please contact us if you would like to obtain a copy of the third party sources.