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Loss aversion
“Loss aversion” means people often feel worse about losing something than they feel good about gaining something similar. Studies show that the discomfort of losing is much stronger than the joy of winning, whether in gambling or stock trading.
In investing, this feeling can be harmful. It might make you hold onto something that’s losing value just to avoid the regret of selling it at a loss. This fear can cloud your judgment and stop you from cutting your losses early. Often, people might buy more of a losing investment hoping to break even. This strategy can work. However, it requires a clear, rational assessment of the investment’s potential to recover its value. Losses can make us feel incompetent, which is very discouraging.
Imagine another scenario: you invest in something, its value rises, and you feel great. You decide not to sell because you think it will keep going up. But then it starts to drop. Even if you’re still up overall, it can hurt to think about what could have been if you had sold at the peak. This regret can be very painful.
There’s no simple way to handle this kind of pain. Just like there’s no cure-all for heartbreak, investing always carries a risk of disappointment. However, you can lower this risk by diversifying your investments, planning for the long term, and matching your risk level to your comfort with potential losses. Adjusting how much loss you can tolerate might take time.
Gambler’s Fallacy
We’ve looked at several biases, and now we’ll explore a common misconception known as the Gambler’s Fallacy.
Consider a game of roulette as an example. In roulette, half of the numbers are black and half are red. (there is also a single green zero, and sometimes even two). The Gambler’s Fallacy is a mistaken belief that suggests that if the wheel lands on red several times in a row, black is due next. However, each spin of the wheel is independent. The odds of landing on black or red are always the same. This holds true regardless of previous outcomes.
This same fallacy appears in the investment world, where it can mislead investors into expecting that a continuously rising asset must soon fall, or a falling one must rise. While it might seem logical that a correction could happen, this belief isn’t reliable. For instance, consider the technology stocks on the U.S. stock exchange, which saw consistent growth from 2010 to 2022. Predicting when this growth would reverse based purely on duration is speculative at best. Although market corrections can occur when enough investors believe an asset has peaked and sell off their holdings, leading to a self-fulfilled prophecy, such events are rare.
To avoid the Gambler’s Fallacy in investing, base your decisions on thorough analysis and careful judgment of the assets, without overemphasis on their past price movements.
