INVESTORS ARE OFTEN described as risk averse. But in truth, we aren’t risk averse, but rather loss averse. We tend to think less about our absolute level of wealth and more about changes in our wealth relative to some reference point—and we hate it when we fall below that value.
It’s been estimated that, for many of us, the pain we get from losses is at least twice as great as the pleasure we receive from gains. This helps explain why so many folks avoid investing in stocks, despite the market’s impressive long-run performance. Federal Reserve figures indicate that only half of Americans own stocks and stock funds.
Our loss aversion also affects how we handle individual investments. Let’s say we buy a stock and its price declines. Often, we’ll refuse to sell the shares for less than we paid, even though unloading the stock at a loss could reduce our taxes. Why do we refuse to sell? That would mean admitting we made a mistake, with all the associated pangs of regret. By contrast, if we hang onto the shares, we can tell ourselves that it’s just a “paper loss” and there’s always a chance the stock will come roaring back. We might even buy more of the stock while it’s down, taking extra risk in the hope of recovering more quickly from our loss.
This aversion to realizing losses isn’t always a bad instinct. In a broad market decline, it can prompt us to hang tough, as we wait to “get even, then get out.” What happens if our patience is rewarded and our losses become gains? Often, we’ll rush to sell, because it feels good to sell our winners—even if it’ll mean a bigger bill at tax time. Studies have found that investors are slow to sell their losers and quick to sell their winners, a phenomenon known as the disposition effect.
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