Loss Aversion

In This Article

• Loss aversion is a concept from behavioral economics, highlighting the tendency of individuals to prefer avoiding losses over acquiring equivalent gains.
• The loss aversion bias is particularly common in stock investing, where emotional reactions to market fluctuations can significantly impact decision-making.
• The investors in the stock market influenced by loss aversion are prone to behave irrationally, potentially undermining their returns and performance.
• Loss aversion is considered a cognitive bias that can contribute toward suboptimal investment decisions, such as holding onto losing stocks for too long or selling winning stocks prematurely.
• The irrationality driven by loss aversion is attributable to the emotional impact of potential losses, which often outweighs the satisfaction of gains (i.e. the outsized fear of incurring a loss dictates one’s decisions).

How Does Loss Aversion Work?

The loss aversion bias is a behavioral finance and economics theory that challenges the implicit assumption of most traditional economic models that presume purely rational decision-making.

The concept of loss aversion emerged from the research of psychologists Daniel Kahneman and Amos Tversky, who developed prospect theory in the late 1970s.

The profound impact of their research eventually led to Kahneman being awarded the Nobel Prize in Economics in 2002 for his contributions and becoming a household name in the field of behavioral finance.

Prospect theory, widely recognized as one of the most influential theoretical frameworks in the social sciences, introduced and popularized the concept of loss aversion.

The premise of the prospect theory states that individuals tend to feel the pain of a loss far more acutely relative to the pleasure of an equivalent gain.

Kahneman and Tversky’s research found that people prefer smaller-sized yet guaranteed outcomes over larger-sized, riskier outcomes, even when the expected return on the riskier option is much higher (i.e. “potential upside”).

In fact, the psychological pain from incurring a loss is estimated to be approximately twice the impact compared to the pleasure derived from receiving a gain of equal value.

The implication of loss aversion is widespread and far-reaching, including investment decisions and the strategic allocation of capital in financial management.

If subject to loss aversion, investors have the tendency to prefer the route to avoid incurring a loss over receiving an equivalent gain.

The combination of the aforementioned principles results in a value function steeper for losses than gains, illustrating the essence of loss aversion.

The understanding of loss aversion has led to the development of nudge theory and other behavioral interventions to improve decision-making outcomes in various domains.

On the subject of behavioral finance, or investing in particular, the practical concepts that pertain to loss aversion are as follows:

• Disposition Effect ➝ The disposition effect refers to the tendency of investors to continue holding onto losing stocks for too long—instead of cutting their losses—while selling winning stocks too soon.
• Sunk Cost Fallacy ➝ The sunk cost fallacy states that investors are often reluctant to sell an investment because of the attachment to the original thesis and the time spent performing diligence on the potential investment.
• Status Quo Bias ➝ Where individuals prefer the current state of affairs due to the perceived risk of loss associated with change.
• Dissonnance-Reducing Buying Behavior ➝ Classified as part of consumer behavior, dissonance-reducing buying behavior describes the fear of investors on making the “wrong” decision (and feeling regret or remorse later on) — i.e. the pain of potential remorse post-purchase outweighs the potential upside if “right.”

Loss Aversion in Riskless Choice

“Loss aversion implies that the impact of a difference on a dimension is generally greater when that difference is evaluated as a loss than when the same difference is evaluated as a gain.”

— Amos Tversky and Daniel Kahneman

^{Illustration of Value Function (Source: Loss Aversion in Riskless Choice)}

What are the Characteristics of Loss Aversion Theory?

Loss aversion theory is characterized by several psychological mechanisms that determine how individuals perceive (and respond) to circumstances where the risk-return trade-off must be considered.

What is the Risk of Loss Aversion Bias?

The behavioral pattern caused by loss aversion can lead to a multitude of adverse outcomes, presenting material risks to one’s performance.

• Suboptimal Decision-Making ➝ The influence of loss aversion may lead to poor financial choices, such as holding onto losing investments for too long. The overemphasis on potential losses can result in missed opportunities.
• Overcautious Behavior ➝ The excessive avoidance of risk in business or personal life can hinder innovation and growth. The overwhelming fear of potential losses often leads to this overcautious approach.
• Sunk Cost Fallacy ➝ The tendency to continue investing in failing projects due to past investments is partly driven by loss aversion. The difficulty in cutting losses and moving on is a common manifestation of this fallacy.
• Negotiation Disadvantage ➝ One’s judgment is prone to become more short-sighted with a narrow focus on avoiding concessions rather than searching for an amicable outcome, a sub-optimal strategy for negations if the decision-making process is influenced by loss aversion.
• Resistance to Change ➝ The stagnation and lack of adaptability in organizational settings can be attributed to loss aversion. The potential for companies to fall behind more risk-tolerant competitors is a significant concern.
• Emotional Stress ➝ The fixation on the potential downside and fear of incurring losses contributes to the accumulation of stress and anxiety, which negatively impact one’s mental well-being and decision-making capabilities (i.e. impaired judgment).
• Opportunity Costs ➝ The avoidance of potentially beneficial risks due to loss aversion can result in significant opportunity costs over time. The underperformance in various aspects of life and business is often a result of these missed opportunities.

How to Overcome Loss Aversion

The awareness of loss aversion is the first step towards mitigating its effects on decision-making.

Overcoming loss aversion is easier said than done because cognitive bias is deeply ingrained in human psychology.

However, the objective is not to eliminate the consideration of potential losses but rather to achieve a more balanced approach to decision-making that weighs both potential gains and losses appropriately.

The following strategies can help individuals overcome the loss aversion bias.

Loss Aversion Bias Example: Stock Investing

Suppose an institutional investor decides to obtain a significant stake in the common stock of Nikola Corporation (NKLA), a publicly traded company that garnered considerable attention and capital funding around 2020.

Nikola Corporation—founded in 2014 by Trevor Milton—sought to revolutionize the transportation industry with its electric and hydrogen-powered trucks.

Upon going public through a SPAC merger with VectoIQ Acquisition Corp. in June 2020, Nikola continued to receive significant attention from the press, with many market participants even comparing the company to Tesla (TSLA), its supposed rival, per Ark Invest’s Cathie Wood.

By promising zero-emission vehicles, Nikola positioned itself as a potentially transformative player in the automotive industry. However, the company’s positive trajectory was short-lived after its outlook (and share price) took a dramatic pivot following serious allegations of committing fraud.

The catalyst? Hindenburg Research released a comprehensive report accusing Nikola of misleading investors about its technology and production capabilities in September 2020.

The widely-distributed report claimed that a promotional video of the Nikola One truck—which appeared to be driving under its power—was in fact, filmed rolling down a hill instead.

To make matters even worse, more allegations emerged on the exaggerated claims about the progress of Nikola’s hydrogen fuel cell technology and the capabilities of its Badger pickup truck, which reportedly existed only as renderings and prototypes.

The flood of complaints from investors in the market and the mounting allegations resulted in the SEC and DOJ stepping in to investigate Nikola, culminating in securities fraud charges against Milton in July 2021.

The fraud allegations significantly impacted Nikola’s stock price and market perception, which seem irreparable given that Trevor, now a convicted felon, was the face of the company (and the fraudulent marketing scheme).

^{Trevor Milton Sentenced To Four Years In Prison For Securities Fraud Scheme (Source: U.S. Department of Justice)}

Following the Hindenburg report, Nikola’s stock price plummeted by over 40%, reflecting the negative investor sentiment around the company’s future and concerns over the allegations (and potential legal repercussions). Hence, the stock price has continued to exhibit an uptick in volatility, fueled by regulatory scrutiny, negative press, and underperformance.

However, while most investors who purchased Nikola’s stock at higher prices incurred substantial losses as its value seemingly fell off a cliff, suppose that the institutional investor decides to hold onto their shares (or perhaps even purchase more to reduce the average price paid per share).

The reluctance of the institutional investor to “cut their losses” illustrates the loss aversion bias, where the fear of realizing a loss can hinder rational decisions to sell their losing investments and reinvest in potentially more profitable opportunities.

The loss aversion bias applies to all investors in the stock market—on the retail and institutional side—because refusing to admit that one’s original thesis might have been inaccurate is an inherent flaw of many investors, particularly those who are provided external capital for their expertise at understanding the public equities market.

In June 2024, Nikola’s stock price hit a record low of $0.32 following a reverse stock split and ongoing concerns about its financial health and production capabilities.

The stock price of Nikola has seen a year-to-date (YTD) decline of over 40%+ as of the midpoint of 2024, highlighting the company’s continued challenges.

^{Nikola Stock Price Chart (Source: NASDAQ)}