Loss aversion

In short

I once watched a friend hold a losing stock for six years because selling it felt like admitting a mistake. You have probably done something like it, and there is no shame in that. Loss aversion is the habit of feeling a loss more sharply than a gain of the same size. Knowing about it will not cure it, but it may help you slow down before you act. When you feel the urge to sell in a panic or to hang on out of pride, wait a day and write down why. Ask yourself one plain question: is this the choice I would make today, knowing what I know now? Try setting your plan in calm weather, so that stormy days do not write it for you.

The whole of it

What it is

A friend of mine once found a twenty dollar bill on the sidewalk and felt a small lift. The next week he lost a twenty in a coat pocket and felt sick about it for an hour. The two events were the same size. The feelings were not.

That gap is what researchers call loss aversion. It is the tendency to feel the pain of losing something more strongly than the pleasure of gaining the same thing. Daniel Kahneman and Amos Tversky described it in their prospect theory work, published in the journal Econometrica in 1979. They found that people weigh losses and gains differently. In their findings, the pain of a loss looms larger than the joy of an equal gain.

You are not broken if you feel this. Most of us feel it. It is easy to guess that an instinct to guard what we have once served people well when food was scarce. That is only a guess, but the same instinct can trip us up when we handle money.

The idea also shows up in what people call the disposition effect. That is the habit of selling winners too soon and holding losers too long. Terrance Odean studied this in a paper on individual investors, published in the Journal of Finance. It fits the pattern. A gain feels good to lock in. A loss feels bad to admit, so we wait and hope.

How it works

If you are holding an investment that has dropped, you may notice a quiet voice saying, "Just wait until it gets back to what I paid." That voice is worth understanding. It treats your purchase price as if it were a promise. It is not one.

Here is the heart of it. Your purchase price is a fact about the past. The market does not know it and does not care. What matters for your next choice is what the thing is worth now and what you expect from it going forward. Money already lost is gone whichever way you decide. Economists call it a sunk cost, meaning money spent that you cannot get back.

Loss aversion feeds on a frame. When you look at one holding by itself, a drop feels like a defeat. When you look at your whole plan over many years, one drop is a small bump. Researchers have written about this too. Shlomo Benartzi and Richard Thaler wrote about myopic loss aversion in the Quarterly Journal of Economics in 1995. Their point was that people who check their portfolios often see more losses, and so they feel worse and take fewer risks.

Think about that on your own porch. If you looked at a field every hour, you would see weeds and mud. If you looked once a season, you would see a crop. How often you look changes what you feel. It does not change what the field is doing.

The numbers, and where to find yours

The size of the effect is not one fixed number. Some studies have reported that losses feel about twice as heavy as gains, but I would not lean on that figure. The strength of the feeling differs from one person to the next. The honest lesson is smaller and more useful. Your own feelings are the number that matters, and you can learn them.

Here is how to find yours. Look at the last time you sold an investment in a hurry or refused to sell one. Write down the date, what you did, and what you felt. Then note how the price moved in the weeks after. This is your own record, and no one else can supply it.

For the facts about your accounts, look at your own statements. Your account statement shows your cost basis, which is what you paid, and your current value. Your brokerage website will list both. For the tax side of a sale, the Internal Revenue Service explains capital gains and losses in Publication 550, Investment Income and Expenses. It also explains how a loss can offset a gain on your tax return. The yearly limit on how much net loss you may deduct against other income is the current figure, which the official source publishes each year. Check the IRS page for the current figure and its date before you count on it.

A worked example

Let me tell you about a woman named Maria. She is forty five, works as a school nurse, and earns 52,000 dollars a year. She saves 3 percent of her pay in her workplace plan, and her employer matches that 3 percent.

Maria bought shares in one company for 5,000 dollars. A year later they were worth 3,500 dollars. She felt the loss every time she opened her statement. She told herself she would sell once it climbed back to 5,000 dollars.

Let us check the numbers. Her paper loss was 5,000 minus 3,500, which is 1,500 dollars. That is 1,500 divided by 5,000, or 30 percent of what she paid.

Now look at what her wish requires. To get from 3,500 back to 5,000, the shares must rise by 1,500 dollars. That is 1,500 divided by 3,500, which is about 43 percent. So a 30 percent drop needs about a 43 percent climb to break even. That gap surprised her, and it is why waiting to "get even" can take longer than we hope.

Then Maria asked herself a plain question. Suppose she had 3,500 dollars in cash today. Would she put all of it into this one company? She thought about it and said no. That told her something. She had been holding the shares mostly to avoid the sting of a loss.

Her savings tell another side of the story. Her 3 percent of 52,000 dollars is 0.03 times 52,000, which is 1,560 dollars a year. Her employer adds the same 1,560 dollars. Together that is 3,120 dollars a year going in without a fight. She noticed that she never lost sleep over that steady habit. She only lost sleep over the one shaky bet.

Maria chose a calm route. She wrote down her reasons, waited a week, and then decided based on what the shares looked like from today forward, not on what she paid. Whether she sold or kept them, she made the choice on purpose. That was her win.

Where it goes wrong

I have made this mistake myself, so I say it kindly. The first way it goes wrong is waiting to break even. You tell yourself you will sell when the price returns to what you paid. The market has no memory of your price. Waiting can cost you years.

The second way is running from every dip. You sell during a scare to make the bad feeling stop. Then the price recovers and you are left on the sidelines. It hurts twice, once going out and once watching.

The third is checking too often. If you open your account every day, you meet more red numbers. Each one stings. You might act on a sting that a calm year would have erased.

The fourth is hiding. Some folks stop opening their statements because the news might hurt. That avoids the feeling but also avoids the facts, and you cannot steer well with your eyes shut.

The fifth is treating tax pain as a reason to freeze. A sale at a loss can sometimes lower a tax bill, as Publication 550 explains. But the wash sale rule can disallow that loss if you buy the same or a very similar security within a set window before or after the sale. Read the IRS explanation for the exact window before you act. Do not let a tax fear or a tax hope run the show.

Feelings are part of being a person. Noticing them is a fine place to start.

Questions to answer before you leave this page

When did you last hold something too long because selling felt like defeat, and what did that wait cost you? If you had the money from a losing holding in cash today, would you buy it again at this price, and what does your honest answer tell you? How often do you check your accounts, and does that habit leave you calmer or more rattled? What plan could you write down now, while you feel steady, so that a bad week does not make your decisions for you? And who is one trusted person you could call before you act on a strong urge to sell or to hold?