Psychology of a loss

Humans are Loss averse. And the individual, corporate and society which understand it thrive despite odds.

“How did this stuff ever get published?” was what traditional economists asked when behavioural economists observed that human beings were loss averse. This aversion is at the heart of human psychology and asset pricing. And if professors are fighting over academic leadership over the subject you can understand why the only “loss” Google search can handle today is that of “weight”. The psychology of a weight loss is positive and motivational unlike the psychology of a monetary loss, which can be pretty depressing. But despite all negativity around the subject understanding loss aversion is at the heart of an investment strategy and even being a successful money manager.
Loss aversion can explain why a price “bid” on or off a trading screen is always lower than “ask” prices. It’s not just because sellers always ask for a higher price than what the buyers can pay but because people attach more pain with a loss of “x” than the pleasure they experience with a gain of “x”. In other words people place more value on giving up an item than on receiving it. Giving up is tougher, more valuable and hence a perceived loss.
So it is not the reality of loss that matters but the perception. And propensity to be loss averse is somewhere connected to a real loss. The more one tries to avoid it, the more it grips you. We have seen nations going to over-extended wars until miserable failures, owing to loss aversion. And loss aversion combined with inability to admit or learn from mistakes can only complicate investment decisions, delaying them till they are of no use, as in a capitulation.
The psychology of a loss works against market timing, and clearly explains why masses cycle from complacency to panic. It also explains why entrepreneurs are contrarians, why we are uncomfortable with geographical risks (Indians trading on the Pakistan stock exchange), why very few of us marry foreigners, why very few intra-day traders make profits consistently, why volatility as an index derives its strength from panic, why our over-trading is an extension of loss aversion and why volume rises when the market goes up and vice versa.
Eric J Johnson, Simon Gächter and Andreas Herrmann, professors at University of Nottingham found some interesting patterns linking loss aversion with various parameters like, age, income gender, education etc. Age seems to be an important moderator of loss aversion. The older we get the more loss averse we are. Gender is an insignificant predictor for loss aversion. So being a woman trader or investor has no intrinsic disadvantage. The study concluded that loss aversion is not a constant. Rather a substantial amount of loss aversion can be explained by the decision maker’s knowledge of the attribute and the attribute’s importance to the decision-maker.
Antonia Bernardo, professor at University of California, Los Angeles, talks about how irrational overconfident behaviour can persist. Information aggregation is poor in groups in which most individuals herd. Shinichi Hirota of Waseda University and Shyam Sunder of Yale talk about how investor decision horizons influence the formation of stock prices. In long-horizon sessions, where investors collect dividends till maturity, prices converge to the fundamental levels derived from dividends through backward induction. In short-horizon sessions, where investors exit the market by receiving the price (not dividends), price levels become indeterminate as they lose dividend anchors. It’s in this case that investors tend to form their expectations of future prices by future expectations. These reasons are important contributors to the emergence of price bubbles. No wonder aggregate markets look for dividends at bottoms and forget them at market tops.
Building on loss aversion, Ravi Dhar (Yale) and Alok Kumar (University of Texas at Austin) analysed the impact of price trends on trading decisions of more than 40,000 households with accounts at a major discount brokerage house and found that buying and selling decisions of investors in the sample were influenced by short-term (less than three months) price trends. They classified investor heterogeneity in trading based on prior returns into momentum buy, momentum sell, contrarian buy or contrarian sell category. The trading behaviour of all the groups exhibited systematic differences in expectations and behaviour. The study could find support to the commonly held belief that relatively more sophisticated investors exhibit contrarian trading behaviour. And, the contrarian investor segment had the best overall performance and their portfolios exhibit better characteristics in comparison to the momentum investor segment.
It’s easy to be a momentum buyer or seller. There’s nothing easier than riding a trend down or up. Unfortunately, riding a roller coaster has its risks and it is not consistent and healthy for a long-term portfolio. There’s more burn effect. A majority of the economic society does not understand this link in profits, markets, psychology and economics. But a few corporate understand and are already strategizing to be ahead. Merck, for example understands this loss aversion and is rewarding scientists for failure. Inability to admit failure leads to inefficiencies in the industry. Despite the Vioxx failure, Merck’s new speed at developing drugs has surprised competitors. Companies are also questioning the fake shareholder power connected with momentum investors with average time durations of ownership barely a few months. They push companies to beat estimates unmindful of the company’s long-term strategy.
The observations and questions we have raised here have a bearing on where we will head tomorrow. When a society becomes loss averse, it looks for a fast buck, looks for more credit driven speculation than real investments, ownership horizons keep getting shorter and loss aversion reaches contagion extremes, as majority sits on the edge ready to exit with the gain. It’s when we reach there, its time for a painful restructuring. Developed markets may still get you 33 cents per dollar claimed after you sue your broker. But developing markets where legislation itself is weak, we are eons away from suing any Dalal Street broker. And both the pain and loss is for us to keep. The faster we understand the psychology of a loss, the better it is for us and for the market.