How To Perceive Gains and Losses

  • Post category:The Principles
  • Reading time:6 mins read

The pain of losing is psychologically twice as powerful as the pleasure of gaining. These were the findings of Daniel Kahneman and Amos Tversky’s published paper, “Prospect Theory: An Analysis Of Decision Under Risk.” You may not know, but it is also a reason why a lot of us buy insurance. The term is also called Loss Aversion. Loss Aversion is behavioral finance where an investor tries to avoid losses more than making a profit. Loss Aversion is supposed to prevent me from taking perceived financial risks. For me, the term “perceived” is vital because it means different things to different people.

In the same paper, They also found out that I would rather win 100 dollars with certainty rather than betting double or nothing on a coin toss. So with loss aversion and prospect theory already built-in by default in most of us, why do many investors fail?

In theory, it has different flavors. I might be willing to hold my losers because my loss is not realized until I close my positions. It helps me avoid psychologically facing the hard facts. Also, Not selling a stock that I hold even after my targets were achieved & the fundamentals clearly state that it is in an overvalued category. Or, Selling a stock a little too early to gain a small amount when I could have made a significant profit holding it for longer. It technically means that this in-built loss aversion concept is doing more harm than good. In practice, it means If I buy a stock of a company at 500$ and it shoots up to 1000$ and then comes back and settles on 650$, It still feels like a loss. However, If that stock first went down to 400$ and then shot up to 650$, It feels like a net gain.

There are other behavioral characteristics at play as well. Let me explain using another example. When given a choice b/w 100% chance to win 90$ and 90% chance to win 100$, I would instead go with the first option because it’s certain. But when the same question results in a loss, my answer changes. Instead, I would take a 90% chance of losing 100$ than a 100% chance of losing 90$. In theory, I risk and gamble more amount in the hope of losing nothing. It is because we all have a risk-seeking side. I take more risks in the hope of not losing anything. 

Another reason is rewards of uncertain size tend to motivate us more than known size. This effect only arises when people focus on the process of pursuing the reward, not when they focus on the outcome. For example, I will be more motivated and work harder if I know I will get some unknown bonus, But I won’t work harder if a 10% bonus is known, even when a 10% bonus was a bigger reward. In a study to see this effect in action, Two groups were asked to bid on boxes of chocolates. The boxes contained either a certain amount of 5 chocolates or an uncertain amount of 3 or 5.

Half from each group was asked to focus on the actual bidding process, whereas the other half was asked upfront how much they’d be willing to bid for the box. The findings showed those who were made to focus on the process risked more money for uncertain rewards. They bid around $1.50 for the 3-5 uncertain item box instead of only $0.80 for the certain five-item box. It means that I have more chance of succeeding in investing if I upfront calculate valuations and the price I am willing to pay for a company instead of buying on a couple of good news when prices skyrockets. In investing, we try to pay more for less valuable companies because of the uncertainty of reward. That is why I started to pay more attention to the certainty of doubling money in the next five years than wishing and buying into a cash-burning company that may or may not quadruple in one year.

In yet another behavioral bias, We humans discount the near future more than the distant future. It is called Hyperbolic Discounting. e.g., We perceive a value of 100$ from 3 years from now a lot less than it should be. It is a broad topic in itself, but the jest is that market can dramatically undervalue strong businesses when it goes into panic mode. Assuming no change to the company’s long-term cash flow or earnings growth, hyperbolic discounting by market participants will drive its share price lower. 

After reading the book ‘Influence,‘ written by a psychologist, Charlie Munger said, “..filled in a lot of holes in my crude system.” We all suffer from psychological and behavioral biases. As an investor, it is imperative to know about humans’ biases and natural tendencies to behave in specific ways in a given scenario. So that we can learn, we carve out our ways to deal with them instead of just following the mob.

I intend to learn from my old mistakes and use them to guide me in my future decisions. I now know why I felt pain when investments were down, Why I did the things I did. It all comes to behavioral finances than informed decisions. First, I need to master my emotions. Before starting with the basics of valuations, I want to know all biases that might impact my decisions. I now understand that investing is more psychological. It’s more of an art than science.