Loss Aversion And Sunk Cost Fallacy
Warren Buffet advises us to be greedy when others are fearful and fearful when others are greedy.
But is it that easy to do?
Imagine the fall seen during the covid-19 outbreak. There was blood on wall street and hence difficult to resist fear. However, if we could understand how greed and fear affect our financial decisions, we might be able to react in a better way.
In this book the author has spoken about a few biases such as:
- Loss Aversion: the fear of making a loss
- Sunk Cost Fallacy: The inability to forget money already spent
- Status Quo Bias: Inability to make new decisions (Decision Paralysis)
- Endowment Bias: Tendency to have affection towards stocks already held in the portfolio and resisting change.
The first two are covered in this chapter while the other 2 in subsequent chapters.
Let's dig deeper into the concept of loss aversion.
Let’s say you are given ₹1000 with two options-
A. Fixed gain of ₹500
B. Flip a coin, if heads – get ₹1000, if tails – get nothing
In a survey, most of the people chose option A.
Let’s take another example,
A. Fixed loss of ₹500
B. Flip a coin, tails you lose ₹1000, heads you lose nothing.
Here, in the survey, the majority chose option B.
If you have studied probability, in both examples, the expected cash flow was the same, ₹500 so you should have been indifferent ideally.
But choosing option B in the second example and option A in the first suggests loss aversion. Since a fixed loss of ₹500 is unbearable, we would take the risky option B, wherein the chance of losing nothing was also there.
Whereas in the first example, sure gain is preferred than bumper gain involving luck/chance.
Loss aversion is there in our mind subconsciously and has the following effects on us.
- Preference for fixed income over equities
- Booking profits early on fear of losing the gain
- Taking more risk than warranted due to instability of mind. Remember, in the stock market, people are loss averse (loss fearing), not risk averse.
- Hold on to losers and sell the winners.
- Tax aversion is the resistance to pay taxes. Subconsciously we want to pay less tax which leads us to generating lower income. The trick is to always count your income net of tax.
The author gives an example here; you own ₹50,000 worth of Wipro which cost ₹25,000 and ₹50,000 worth of TCS which cost you ₹1,00,000. If you urgently need ₹50,000, what would you sell? Majority of us would sell ₹50,000 worth of Wipro due to loss aversion. The correct method as suggested by the author is to sell half of both. This way you complete your money requirement, pay lower taxes and keep a portion of your winning stock in the portfolio as well.
Now, let's delve deeper into another bias called Sunk Cost Fallacy.
Why do people continue to do things they don’t like? It's because they have already invested time or money in it, and leaving it incomplete would mean wastage of time. Think about a course you got enrolled into. In the mid-way you realize that you are not interested in the course. Would it make sense to still complete it? No, because the money you have spent is not going to come back, but the additional time that you are spending could have been utilized in a better manner.
Sunk cost fallacy in case of stock markets is seen when investors keep on averaging a loss-making stock as it goes down. The reason is they don’t want the money already invested to go to waste and hence would put in more money to lower the cost of acquisition. This makes no rational sense and hence the author advises us to come out of this fallacy.
The following methods will help you make better investment decisions.
- Start with an assumption that your appetite for losing money is less than it actually is. This will help you give more time in investment decision making and chances of regret are reduced.
- Diversify across asset classes and within asset classes as well. The best way to not regret loss (loss aversion) is to not have a loss. Diversification is a full proof measure for reducing portfolio risk. Diversify across asset classes like equity, bonds, gold, etc. to earn optimum returns and reduce risks.
- Total portfolio vision. Have a look at the total portfolio value rather than individual stocks whenever a news hits your stocks. When you do this, you are less scared as a well-diversified portfolio seldom crashes as individual stocks.
- Let bygones be bygones. Don’t chase a stock just to lower the cost. Ask yourself each time it urges you to average a loss-making stock, if I did not own a single piece of this stock today, would I still buy it?
- Segregate gains and integrate losses. An interesting concept from Weber's law, which is that two moderately-bad experiences exceed the pain of experiencing both at one time, can be used in the stock market as well. When you want to book a loss, book it in one go, rather than segregating it. On the other hand, when booking profits, be a miser and slowly book it.
- Spend less time in front of the screen. A semi-annual portfolio review is justified.