InSight

Essential InSights

Core Topics for the Everyday Investor

Investment Bias: Loss Aversion

Investment Bias: Loss Aversion

Loss aversion is the tendency for people to strongly prefer avoiding losses at the detriment to obtaining gains. This puts an unnecessary fear on an investment not supported by the risk prima. This might be one of the most common biases that hinders the success of a retail investor. Simply put, investors refuse to sell loss-making investment with the hope of making their money back. A fear of making the loss “permanent” and along the way missing other opportunities, and likely impairing their returns. The fear of losing, causes more losing.

It is reminiscent of the gambler who goes back to the same table to get “back on top.” 

Traders are reluctant to abandon a loss maker for a fidelity to risk that they are not being rewarded for. What is important to remember, is that these stocks don’t know we own them, and there is no reason a stock cannot be rebought if/when conditions improve. Likewise, it’s important to note that the money doesn’t need to be gained, the same way it was lost. This tunnel vision on a stock or industry is another by product of loss aversion.   

The loss-aversion tendency breaks one of the cardinal rules of economics; the measurement of opportunity cost. It breaks the second rule by letting emotion drive the decision. To be a successful investor you must be able to properly measure the opportunity cost available. Similar to anchoring, Loss aversion is being attached and inflexible to a previous value or cost and stems from a human tendency to avoid losses.

Investors who become anchored due to loss aversion will pass on mouth-watering investment opportunities to retain an existing loss-making investment in the hope of recouping their losses.

It is hard to determine when a cost is “sunk” if the purchase price is always contaminating the rational. Instead investors should resort to the valuation metrics that have likely deteriorated in the stock, and evaluate that to the opportunities they are missing by caring their overweighed fidelity to a position.

essential insights

Other Related Topics:

Definitions: Fixed Income

Fixed Income (or debt) represents your ownership over the repayment of a debt. Usually considered bonds, they are contracts promising the repayment of loaned money. Other forms of debt arrangements include Mortgage-Backed Securities, liens, loans, and CDs. Fixed income is called that because the return is decided on the outset – so the return is fixed from the initial offering. Because the upside is fixed from the start, the change in their pricing is less dramatic. Thus, fixed income pricing becomes less about the asset itself, and more about the prevailing rates for other options (read “current interest rate environment”). Debt is usually priced based on three variables, 1) How likely you are going to get your debt repaid, who owes the borrowed money, and what is the way they will pay it back? (Taxation, revenue, etc.) 2) how long until you are repaid your initial investment, this is called duration and indicates how long the money is at risk for. 3) the rate that the debtor is paying on the borrowed sum, usually expressed percentage as a coupon or yield. There are subcategories based on who the entity requesting the money fall into: Muni’s  – a Districts or Municipalities Debt. Usually issued to fund special projects, schools, or city and municipal improvements. In addition to the yield, these are priced for risk based on cities’ credit history, the source they plan to repay the loan (taxation or toll-based), and any available insurance they put on the bonds. Treasuries – the sovereign debt of a country. This is debt usually supported by the taxing authority of a country and its ability to create (fiat) the money they need. This is priced based on the credit rating of the country, the outlook of its currency, and the yield. Corporate – debt issued by companies and priced based on their creditworthiness. These are divided into investment grade and non-investment grade (called affectionately “high yield”) and then subdivided further. Certified Deposits (CD’s) – debt issued by banks. These are usually issued in small increments and for a short duration. The returns are insured by the FDIC (federal government) Mortgages (MBS) – These are backed by the creditworthiness of the borrower, and usually the risk is mitigated by grouping a pool of mortgages into tranches based on their collective credit rating. Collateralized Debt Obligations (CLOs) – Similar to the mortgages, this is a collection of debts that secure equipment or are backed by specialty financial arrangements.  Often backed by the repossession of accounts receivable or equipment.  

Read More »

Definitions: Equity

The term Equity represents any ownership rights over an asset’s cash flow generation potential. As an asset class, there is no guarantee of a return on your investment, it is the most speculative of assets classes and is the only asset class that can have its intrinsic value brought to zero. But because it is ownership without end, and a right to the value in perpetuity, it is also the source of the greatest returns. The math looks like this: The most common sources of Equity are stocks, your home, and other real estate assets. But equities can also include ownership in a business through your own formation, or as the result of a private placement and they also include art, royalty agreements, or leasing agreements.  Other terms for Equity are shareholder value, book value, or stake.

Read More »

Definitions: Asset Allocation

Asset Allocation is how we discuss the percent of assets in one of the four main asset classes. It is the balance of risk and reward and is the most reliable leading indicator of the intermediate and long term trajectory of a portfolio. The Asset Allocation is the first place we can adjust to a client individual’s goals, risk tolerance, and investment horizon. Asset allocation is often displayed as a pie chart and discussed in terms of the ratio. For example, the “60/40” is a shorthand reference to a portfolio that is 60% allocated to equities, and 40% to debt. These are used by many firms to place clients into a suitable collection of investments. The four assets classes we define in Asset Allocation are Equity, Fixed Income, Cash, and Precious metals.

Read More »

Pin It on Pinterest