Behavioral Bias In Markets Part 2: Loss Aversion


Continuing our series on market bias, I want to touch upon the next most important element- Loss aversion. This is a term introduced by Daniel Kahnman. We tend to overrate the loss of an amount over the pleasure that a gain of the same amount gives us. A loss of a few thousands in the market is a lot more painful than a gain of a similar few thousands. Ideally, the value of the few thousands ought to be the same. But to our minds, they aren’t and that is the damndest thing! Kahnman says this is particularly prevalent in the market and my experience in the market says that this is one of the most vital reasons why traders end up with a bigger loss than they bargained for when they got in.

Mark Douglas has gone to great lengths to show in his books as how our minds are literally wired to avoid losses. So, if you take this natural setting and mix in the Loss Aversion bias, then it is a killer combination that has you doomed from then start! The pain of losses is so high that it puts you into avoidance behavior, a refusal to acknowledge that it is happening, and a slip into a hope state that it will soon go away or become alright. This goes on until, as Douglas has put it, the pain of losing one buck more is greater than admitting to the fact that you are doing what you are doing. Our tendency to avoid losses causes us to make silly decisions and change our behaviour simply to keep the things that we already own. We are wired to feel protective of the things we own and that can lead us to overvalue these items in comparison with the options.

The greatest problem with this behavioural bias is that it makes you either not act in time or makes you act too late. Both of these are wrong and don’t serve you at all in the market. Become aware of this behavioral trait within you and when you spot it (or If), take steps to move out of its clutches by doing the opposite of what it is asking you to do. Difficult to do, of course. But we must, if we have to escape its clutches.
There is much to be said for this bias. But suffice to get an idea that it is an important behaviour characteristic that we carry and that we need to be aware of.

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