Tag Archives: risk preferences

If You Love Something, Set it Free: Avoiding Loss Aversion

Today Mark Hulbert ran an intriguing post in the Weekend Investor section of the Wall Street Journal suggesting that investors should take the opportunity to do some spring-cleaning of their asset portfolios.  Hulbert outlines a very common problem that both lovers and investors face: both are often afraid to end bad relationships. From a romantic context this is ancient wisdom, but to economic and financial researchers, understanding the aversion many investors have to selling their stocks is a relatively new development.

Terrance Odeon, a professor of finance at New York University and principal at AQR Capital Management, describes this concept very succinctly: “for most investors, buying is a forward-looking activity and selling is a backward-looking activity.” Odeon maintains that there are a lot of strange things investors do when they’re faced with selling a stock they own, especially when faced with realizing a loss. For instance, in his article Once Burned, Twice Shy: How Naïve Learning, Counterfactuals, and Regret Affect the Repurchase of Stocks Previously Sold, Odeon and Michal Ann Strahilevitz explain that investor’s previous experiences with a stock affect their willingness to repurchase a stock. After surveying the trading records of several tens of thousands of individual investors, Odeon and Strahilevitz found that investors are reluctant to repurchase two types of stocks: those that they sold for a loss, and those that had risen in price soon after their sale. This phenomenon appears to occur regardless of whether these stocks are reasonably good investments after the initial sale. The reason for this behavior, according to the authors, is the cognitive dissonance, or negative and disappointed emotions, that investors feel when reflecting on their previous investing actions. Many investors are easily manipulated by these emotions, and as a result often tend to follow reinforcing behavior in which they purchase stocks associated with positive emotions and avoid those that inspire negative emotions.

This behavior seems consistent with Amos Tversky and Daniel Kahneman’s research in their article The Framing of Decisions and the Psychology of Choice. In their article, Tversky and Kahneman describe how individuals tend to switch from risk aversive behavior to risk taking behavior depending on how a problem was phrased. For instance, when presented with a hypothetical problem in which a flu outbreak is expected to kill 600 people, with a choice between solutions A: “saving 200 people with 100% probability” and B: “saving 600 people with 33% probability” (which has the same expected value as the other option: 600 people * 33% = 200 people saved), individuals tend to choose option A. In this case, the bias of the participants towards picking the “most positive sounding” answer seems consistent with the Odeon paper where investors tend to choose stocks that they have the most “positive emotions” towards. On the other hand, when participants in the Kahnemann study are presented with the same question but are offered equivalent “negative sounding answers,” they tend to switch their preferences. Here, participants are more likely to choose option B: where there is a 1/3 probability that no one will die (same as the option B in the previous question, since 600 people * 33% = 200 people not dying is equivalent to 600 people * 33% = 200 people saved) over the option A: where 400 people will die for sure (equivalent to option A in the previous question in which 200 people will for sure be saved). In this case, much like in the Odeon paper, individuals tend to avoid the options that inspire negative emotions (the “negative sounding “option where 400 people are certain to die, and the “negative sounding” option to avoid a stock on which they had previously lost money), and tend to choose those that appear “more positive.”

In order to combat these mental biases and to identify stocks to sell, Hulbert offers a few tips to investors. First, he suggests that investors pay attention to the companies  financial analysts have given “sell” ratings to. This is because even financial analysts are reluctant to tell investors to “sell” stocks, so the logic is that if they actually do muster up the courage to give a stock a “sell” rating then the stock likely deserves it.  Along these same lines, Adam Reed, a finance professor at UNC-Chapel Hill, suggests to look at short-interest data (number of people who are “shorting” the stock and hope to profit from a fall in its price) as an indicator of whether or not you should sell a stock. Despite all of the tips offered in Hulbert’s article, it’s probable that the best advice is to take a tip from Tversky, Kahneman, and Odeon: don’t be afraid to cut your losses; the only thing that you should avoid is loss aversion.

Overall, what holds true in love appears to hold true in investing as well: if things are truly not working out, it’s often better to end your love affair (with a stock) than to prolong your suffering.