Loss aversion is a behavioral concept that refers to when someone strongly avoids losses over acquiring gains. The pain of losing $10 is much more painful than the joy of winning $10. In studies of gamblers, most people would only accept a bet if their potential gain was significantly greater than their actual investment. This means that the average person would only take a bet if they could win significantly more than they had to pay to play. This theory can also be directly applied to investing.
For investors, loss aversion comes into play when it is time to make a change to their investments. When making a change, we are faced with the possibility that we may make the wrong decision and, in turn, lose money. We purchase, hoping that our stock does not lose value. However, if the stock begins performing poorly and a change may be necessary, we are faced with questions. Do we sell the stock at a loss and reinvest, hoping for gains? Or do we hang on to the stock and hope it will recover? We often cannot face the pain of taking a loss, and it is in this situation where we struggle with aversion.
The overnight test was invented by Carl Richards, and is an excellent way to look at the aversion predicament. Imagine having a stock that you cannot bear to sell at a loss. After going to bed one night, imagine that the stock has been replaced with cash. Would you buy the stock back now with the cash? By changing your mindset from getting rid of a stock to investing cash, you can take the emotion out of the loss you have been putting off. We must accept that emotion plays a big role in investing and work on how we can overcome our tendencies to make poor emotional decisions. One of the advantages that an independent fee-only financial planner has is that they are not emotionally connected to your money.