Investing also has its emotional side, and this is called loss psychology. This the negative sentiment associated with recognizing a loss and the psychological effects of such to the investor.
Humans tend to have loss aversion bias, which is one of the many biases that behavioral finance studies. According to research, the pain of losing in a certain investment is psychologically about double the power as the joy investors experience when winning an investment.
This fear of losing in investing can be too overwhelming that it makes an investor behave irrationally, thus leading to poor investment decisions.
Breaking Down Loss Psychology
Of course, nobody likes losing. That’s particularly true in the case of money. The fear of incurring a loss can derail an investor’s career. What happens is that he holds on to a losing investment long after he should have sold or offload it. This is a bias known as disposition effect.
Newbie investors usually make the mistake of hoping a stock to bounce back, even if all the evidence point to the opposite result. That’s because realizing and admitting losses cause more emotional effects that gains.
Loss psychology may be result to the asymmetric volatility phenomenon in the stock markets. In this event, the equity market volatility is higher in declining markets than in rising ones.
According to the prospect theory, people more strongly want to avoid losses than acquire gains.
This feeling of loss aversion can be very overwhelming that it can result in negativity bias. In such events, investors put more emphasis on the negative or bad news than the better or good news. The usual result is that they miss out on bull markets, because they fear that they will reverse course. Then they panic when the markets sell off.
To avoid these psychological traps, the investor can follow a strategic asset allocation strategy. They can also use formula investing and diversification. Buy and hold strategies are also very effective.
Benefits of Behavioral Finance and Loss Psychology
Behavioral finance offers some scientific insights into the investor’s cognitive reasoning and investment decisions.
Using behavioral finance, we can understand why market bubbles and market panics take place. Investors need to understand behavioral finance not only to be at an advantageous position on stock and bond market fluctuations but also to be more conscious of their own decision-making processes.
Incurring losses can be helpful to you if you choose to learn from them. The investor needs to look at things objectively and strategically.
After all, losses are inevitable, and this is the reason why successful investors use “loss psychology” in their investment strategies and use coping strategies.
In order to break free from the crippling fear of financial losses and defeat cognitive biases, the investor learns to handle negative events. Afterward, they avoid making panic-driven and emotion-based decisions.
Professional and smart investors focus their attention on rational and careful trading strategies. This prevents them from falling into the common mishaps that happen when psychology and emotions take control of them.