Risk aversion refers to an individual investor’s preference to choose an investment with a more certain, but possibly lower, expected outcome compared to an investment with an uncertain outcome. Individuals often choose investments with low but guaranteed interest rates, rather than investments that have the potential for higher returns, which also come with the chance of declining below the initial purchase cost.
Loss aversion results from the preference of most individuals to strongly prefer avoiding losses to acquiring gains. This occurs because your brain evaluates the emotional impact of losses and gains differently, with losses producing an impact that is more powerful than gains.
Imagine that you have the good fortune of finding $50 on the sidewalk. You place the bill into your pocket and walk to a store that is located in the next block. Once inside the store, you reach into your pocket to pay for a purchase and discover that the bill is gone. Somehow it fell out of your pocket. How would you feel?
Chances are that you would berate yourself over losing the found $50, because the loss has a more powerful feeling even though the true economic impact to you is $0.
Loss aversion explains the reluctance of individual investors to sell investments that will result in a loss.
Imagine that within your investment account you purchase two securities. If you are like most investors, these initial purchase costs will now become your continuing reference points for the success of your investment decisions. One security appreciates and one security declines. You now need to make a withdrawal from the account, so you will have to sell one security to raise the funds. You do not have any new information about either security that may influence your opinion of the future prices of the two securities. Which one would you sell?
Most individual investors would choose to sell the security with the gain, even though the transaction will produce a capital gain that will require a future tax payment. The most rational decision would be to sell the security with the loss, since no tax would be owed and the capital loss can be carried forward indefinitely for tax purposes.
Prospect theory explains this tendency for individual investors to hold on to losing stocks and sell winning stocks. The theory was developed by Kahneman and Tversky in 1979 and resulted in the researchers being awarded the Nobel Prize in economics in 2002. The theory describes how individuals make choices in circumstances where they have to decide between alternatives that involve risk.
The theory builds on the basis of risk and loss aversion, by which individuals value gains and losses differently, and shows that individuals also base their decisions on perceived gains rather than perceived losses. As a result, if you are given two equal choices, one expressed in terms of possible gains and the other in possible losses, you will choose the former, even if it provides the same monetary result.
Individuals tend to decide between which outcomes they see as basically identical, and then set these outcomes as reference points from which they consider lower outcomes as losses and larger ones as gains.
Consider an example where you are presented with $10,000 and then given two choices:
The first choice involves accepting a sure loss of $7500.
The second choice involves accepting a bet that has a 75% chance you will lose $10,000 or a 25% chance you will lose nothing.
Which choice would you prefer?
The probability outcome of both choices is a loss $7500, but most individuals select the second choice. Why? Because they do not like the feeling of losing and the second choice offers a chance that they won’t have to experience the emotional pain of a loss.
The implication of Prospect Theory is that individual investors do not assess risky choices following the principals of rationality. Rather, in assessing such choices, they do not focus on the levels of the final wealth they can attain, but instead view gains and losses relative to some reference point, which may vary from situation to situation.
To the detriment of individual investors, they are willing to assume a higher level of risk in order to avoid the emotional pain of loss. Unfortunately, many securities decline for valid reasons and never recover in price, so there is frequently a financial price to pay for not wanting to feel regret.