As if investing weren’t hard enough already, traders inherently have a number of biases they're constantly battling to overcome to succeed in the world of Wall Street. If you’ve ever felt more concerned about avoiding losses in the market than seeking out gains, you suffer from loss aversion — and you’re not alone.
DataTrek co-founder Nicholas Colas recently discussed the behavioral bias of loss aversion, and it doesn’t just affect investors.
A study of professional PGA golfers by Chicago Booth Professor Devin Pope and Wharton Professor Maurice Schweitzer found that golfers make birdie putts 2 percent less frequently than they do par putts of equal distance.
The reason for this underperformance: golfers tend to focus more when missing the putt could result in losing a stroke on their score.
'Play It Safe'
The same study found that birdie putts were on average both softer and less accurate than par putts, indicating even professionals tend to “play it safe” to avoid a difficult par putt if they miss. On average, the study found loss aversion was significant enough to cost the average pro golfer one stroke per tournament.
In the investing world, Colas said loss aversion is to blame when investors tend to take profits on winning positions too early and hold onto losing positions for too long.
If you are a trader who recognizes this pattern of mistakes in your investing, Colas said setting a clear, well-defined entry and exit strategy before every trade can help.
“Doing so helps cut out irrational behavior stemming from our innate desire to avoid encoding a loss."
These irrational biases can be especially difficult to overcome during periods of extreme market weakness, when fears of heavy losses are most intense.
“Many investors panic out of positions at suboptimal prices during market downturns, for example, or chase performance when a strategy has already lost its momentum,” Colas said.
Overcoming Loss Aversion
Loss aversion is a universal human tendency that can apply to anything from sports to investing to changing jobs. It’s natural to feel strong emotions when making important decisions like how to invest your retirement savings or whether to buy a house.
These emotions are important for our survival and help protect the things we value most. However, the best investors don’t let emotions like fear trump ration and reason.
The Market Effect
This week, the SPDR S&P 500 ETF Trust (NYSE: SPY) dropped 1.8 percent over a two-day stretch, and many investors likely endured heavy losses.
Yet for any investors with long-term investing time horizons and stable near-term financial situations, there’s no reason to be panicking or selling good stocks hand over fist simply out of fear the market sell-off could continue for a few weeks or months.
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