Loss Aversion & Experiential Bias

Loss Aversion & Framing Bias

Investment Optimisation

Loss Aversion & Framing Bias

Your Behaviour and Emotion will play a fundamental role in the assets you both consider and invest into. Two behavioral biases which play a subconscious role in deliberating your choice in assets are Loss aversion & Framing bias and it’s important that you are aware of each.

When it comes to investing our tendency is to preserve our hard earnt money, furthermore, when searching for possible investment opportunities we typically talk to friends and family, whilst researching opportunities that are familiar to us. Moreover, when researching, marketed investment opportunities are highly likely to be framed in a context that is inherently designed to promote a sale or the viewpoint that the asset is a good deal.

Loss Aversion

Loss aversion refers to our tendency to strongly prefer avoiding losses over acquiring gains. This behavior is at work when we make choices that include both the possibility of a loss or gain. For example, when making investment decisions we most often focus on the risks associated with the investment rather than the potential gains.

The loss aversion bias is not always a bad thing, in many cases, it is beneficial to our way of life. Naturally responding more powerfully to threats than to opportunities is a clear example of our innate survival instinct. A benefit of loss aversion when making financial decisions is your ability to be cautious of investments that are potentially harmful to your financial health and future lifestyle.

Commit To Opportunities

On average people generally need to gain about twice (1.5x – 2.5x) as much as they were willing to lose in order to proceed forward with a bet or financial decision without hesitation. This theory was confirmed in an experiment conducted by behavioral experts Amos Tversky and Daniel Kahneman. Understanding that every investment you make is not likely to double your money is a good starting point, but broadening your investment universe from what you are familiar is even better. By considering unfamiliar asset classes and creating numerous investments, this strategy will allow you to increase your diversification, thus minimising the impact of a loss on any singular investment. This strategy both creates and exposes your portfolio to returns that are capable of counteracting the losses experienced in other asset classes.

Commit To Selling

As an investor, you typically don’t acknowledge a loss until you sell the investment and this is because we try to avoid experiencing the pain of a “real” loss. The result is that we may continue to hold onto an investment even as the losses from it increase. By avoiding the psychological and emotional fact that you have made a loss, you risk amplifying future losses by not choosing to sell the investment. The idea or thought process that the loss doesn’t “count” until the investment is closed can cause significant financial harm by holding onto losing investments much longer than you otherwise should. Fintor advises clients to both hold and sell assets that have experienced a loss, but before providing such advice, our professionals investigate the facts of each case. It is important to note that you don’t sell all losses, it the investment is acting independently of a market or sector, then yes, this is cause for concern. However, if a portfolio of assets is falling in value due to a larger macro event i.e. the global financial crisis, it is best to analyze each holding, review the fundamentals and ascertain if the investment is worth selling, holding or purchasing more of.

Limiting Loss Aversion Bias

Importantly, we can’t eliminate loss aversion, but we can be aware of it. A practical strategy to protect against loss aversion is to utilise a stop-loss strategy. A stop-loss strategy is where you set a pre-determined price that the asset will be sold if facing an investment loss. This pre-commitment will help limit risk and help to mitigate a loss aversion bias.  Other examples of how you can reasonably minimize risk exposure and losses:

  • Invest in companies that have an extremely strong balance sheet and cash flow generation.
  • Consciously remain aware of loss aversion as a potential weakness in your investing decisions
  • Purchase investments with relatively low price volatility
  • Hedge an existing investment by making a second investment that’s inversely correlated to the first investment

Framing Bias & Investing

When researching investments, the phrasing or how an investment is “framed”, can cause you to develop an opinion that is either positive or negative. As an investor, it is important that you ascertain the facts and use them as a basis to formulate your opion about whether the investment is good or bad.

What’s fascinating is that when investors are not sure of all the facts, or in a situation where there are many unknowable factors, there is, in fact, a high probability of reflexive decision-making. The probability of being influenced by framing bias is, thus, also increased. For example, which of these two options do you find more appealing?

The Result

Option number one sounds disappointing. Earnings were below predictions and makes the investment sound like the company is struggling.

Option number two however, uses the term “outperforming” and uses a baseline number that makes the company look like it is in an upward trend.

Minimising The Effects of Framing

A solution

One strategy you can do as an investor is to always challenge the framing and how information is presented. Consider rephrasing the information you’re reading and see what impact, if any, that has on your conclusion. The key thing is trying to kick in the logical, reflective approach to decision-making and avoid impulsive, reflexive decisions.

An Example

When reading marketing material about an investment or research paper, typically there is a lot of opinion and bias included in the research and/or marketing material. Try to remove any editorial/judgmental comments and look at only the key numbers and underlying assumptions driving the valuation or reason for the investment. Then arrive at your own conclusions, rather than being swayed by how the information is presented to you.