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THINK! YOUR WAY TO MILLIONS

Excerpt

(Extracted from Chapter 4 – Frame dependence and the impact of psychological barriers on investor behavior)

How many people do you know who like making losses? I haven’t come across too many. Psychologically, most people do not like to make a loss. There is a strong aversion or disinclination towards incurring a loss of any kind. The issue however is that our natural inclination to avoid loses can actually put us under greater risk of loss. How? We will come to that in some time.

Let’s consider a simple illustration first:

Let’s say that you are given two options. If you choose option A, you will incur a sure loss of Rs. 8,000. If you choose option B, there is an 80 per cent chance that you will lose Rs. 10,000 and a 20 per cent chance that you will lose nothing. Which option would you choose?

Majority of the people we administer this problem to choose option B. Why do they do this? The logic is that they stand to incur a sure loss of Rs. 8,000 in the first option. And people have a natural dislike to losses. So, most people choose the second option, i.e. option B because that choice offers them a chance to avoid any loss. This phenomenon is called Aversion to Loss.

Let’s see how this works in a financial scenario, say in an investor’s case:

Let’s assume that you bought two stocks – stock A and stock B. Stock A was bought for Rs. 100,000 and is now worth Rs. 200,000. Stock B was bought at Rs. 300,000 and is also now worth Rs. 200,000. You suddenly realize that you need Rs. 200,000 for your daughter’s marriage. Which stock would you sell?

If you answered stock A as the stock that you would sell, you are perhaps demonstrating an aversion to loss that could cost you money in the long run. However, don’t worry. Most people make that choice because they reckon that they have already made their profits on stock A and the decision to sell off stock A at a profit leaves them happy and satisfied. They want to hold on to stock B because stock B at this point in time is quoting at a rate far lower than what it was bought for. As long as they hold onto it, it is a notional loss (just a paper loss); however, the moment they sell stock B at the current rate it becomes a real loss. And the aversion to loss takes over and stops the investor from selling stock B.

Now look at the above situation again. In essence, what is the investor doing if he sells off stock B. He is actually holding on to a losing investment (an investment that has come down considerably and may actually come down further) and selling off a winning investment (an investment that has already made money for him and may not be anywhere near its peak level as yet). An alternative way of addressing the situation could be to sell of Rs. 100,000 worth of stock in each of A and B. That way, even if stock A were to come down in the near future, he would already have made a decent profit on it. Similarly, he would still gain whether stock B were to go up or down in the future. And he would have to pay no tax on the entire transaction, thereby augmenting his real gains from the two transactions.

There is another way in which investors lose money – that is when their aversion to loss is combined with the habit of procrastination. Consider the above illustration yet again. If the investor continues to hold onto the losing stock just because he doesn’t want to lose part of his investment value, after some time procrastination sets in and the investor will generally not sell even when the stock does move up a little. Aversion to loss and ill-considered procrastination ensure that the investor rarely sells at the opportune time. Finally, the investor may sell eventually at a much higher loss or when the investment has no real value left. Consider what happened to several investors in the 1990’s when they held on to losing investments purely to avoid a loss – eventually, they were left holding stocks that were worth merely the value of the paper held.

 

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