Let’s play a game. I’ll toss a coin and you can call heads or tails. If it lands on the side you called, I’ll give you $100. If it doesn’t, you’ll give me $100. Are you interested? If you’re like most people in the world, you wouldn’t be. First, the game sucks; there’s no strategy, user agency, excitement… But also the odds suck. Losing or gaining $100 on a 50-50 throw means that in 20 rounds of the game, you’ll most likely end up where you started.
Let’s change the game a bit. If I win, I’ll still get $100 from you, but if you win, you’ll get $120. Suddenly, it looks like a better deal. In fact, every round, on average, you’re gaining $10. In 20 rounds, on average, you’d make $200. How about now, do you want to play? If you’re like most people in the world, you still wouldn’t. It turns out that we value losses more than gains. We’re more afraid of losing $100 than we are excited about winning $120. This is called loss aversion.
Loss aversion is a cognitive bias (and economic concept) that describes how the pain of losing is psychologically twice as powerful as the pleasure of gaining. It’s an important concept in behavioral economics and can explain a lot of investment behaviors. This aversion is more powerful than you might expect. A study by Kahneman & Tversky found that the profit needs to be at least 2.5 times as much as the loss for the deal to be attractive. In our coin toss example, that’s $250 profit if you win and only $100 loss if you don’t. If you find someone willing to offer you these terms, please send them my way.
Oh no, Bitcoin crashed! We haven’t seen prices this low since yesterday!
Does loss aversion make sense? Sometimes. Let’s go back to the example where I give you $120 if you win, and you give me $100 if you lose. What if you only had $200 in your bank? If your first two rounds are a loss, that’s it. You’re out, and you’re likely in trouble. Having double your budget for a week is pretty good, but the flip side of having no money for a week is disastrous. In this instance, loss aversion absolutely makes sense. Let’s change the game to winning $12 but losing only $10. The chance of losing your first 20 throws is 1 in 1 million. The chance of dropping below $50 at any point (starting from $200) is only 7%. These are the much better odds. Most economists, mathematicians, statisticians, investment analysts, and compulsive gamblers would play the second game, but most of us still wouldn’t. Because you’re able to take the risk multiple times (due to the reduced loss relative to your total capital), you’re giving probability a chance to catch up to the average (which is you gaining money). This is where loss aversion works against you.
The best approach to loss aversion, and to be “greedy […] when others are fearful” is to understand your risk. The fear of losing all your hard earned money and putting yourself in financial hardship is why loss aversion is good for you. But by only investing what you’re willing to lose, you can then focus on maximising your expected gains and not what to do if you fail. For stocks this means averaging down on a stock you believe in that just dropped in value. For startup investing this means diversifying across startups and reducing your total amount invested to within your risk tolerance.
If it’s money you can’t afford spending, it’s money you can’t afford investing.
Fear of losing will always be present in your investment decisions, which is why managing it with a risk strategy is key. In investing, there is no free lunch, and most good investments contain a degree of risk. Or, as Burton Malkiel put it in his brilliant book A Random Walk Down Wall Street:
Risk, and risk alone, determines the degree to which returns will be above or below average.
Burton Malkiel
