Loss Aversion

Loss aversion is the tendency to feel the pain of a loss more strongly than the pleasure of an equivalent gain. It is one of the best documented findings in behavioural economics. Daniel Kahneman and Amos Tversky described it in their 1979 paper on prospect theory, and later estimates suggested losses feel roughly twice as intense as gains of the same size. Kahneman received the Nobel Memorial Prize in Economic Sciences in 2002, partly for this work.

What loss aversion looks like#

A classic experiment: people are offered a coin flip that wins $150 on heads and loses $100 on tails. The bet has a positive expected value of $25, yet most people refuse it. Many only accept when the potential win is around twice the potential loss. That ratio, roughly 2 to 1, is the loss aversion coefficient often cited in research.

How loss aversion hurts traders#

The combination of cutting winners and holding losers produces the opposite of what most strategies require. See Disposition Effect.

Loss aversion in markets#

Loss aversion also affects how whole markets behave. Investors' reluctance to sell at a loss can create resistance at prices where many people bought, as they sell to get back to breakeven when price returns. It may also help explain why markets often fall faster than they rise: fear of further losses drives rapid selling. See Role Reversal and Retests.

Countering loss aversion#

1. Set stops before entering and place them as real orders, so the decision is made before emotions build. See Stop Orders.
2. Think in R multiples: a loss of 1R is a planned business expense, not a personal failure. See Expectancy.
3. Judge a series of trades, not one. Over 50 or 100 trades, individual losses matter little. See Losing and Winning Streaks.
4. Use smaller size, so each loss is genuinely affordable. See Position Sizing.
5. Pre-commit to exits for winners, with targets or trailing stops, so fear of giving back gains does not cut them short. See Exit Mechanics.
6. Review your journal for average win versus average loss. If average losses are larger than planned, loss aversion is likely at work.

Not all caution is loss aversion#

Protecting capital is essential, and some aversion to losses keeps traders alive. The problem is the asymmetry: being too quick to take gains and too slow to accept losses. The goal is symmetry, treating gains and losses according to your plan rather than according to how they feel.

Common mistakes#

• Cancelling stops to avoid realising a loss.
• Averaging down on losing positions to reduce the visible loss.
• Believing you are immune because you understand the bias.

Frequently asked questions#

What is loss aversion?#

The tendency to feel losses more strongly than equivalent gains, often estimated at roughly twice as strongly.

How does loss aversion affect trading?#

It leads traders to hold losing trades too long, move stops, sell winners too early and avoid trades after losses.

How can I overcome loss aversion?#

Pre-set stops as orders, size positions small, think in terms of many trades and measure your average win versus average loss.

Next, learn about the trading pattern loss aversion creates: Disposition Effect.

Sources#

• Kahneman, D. and Tversky, A., Prospect Theory: An Analysis of Decision under Risk, Econometrica, 1979. Summary: Wikipedia, Prospect theory
• Wikipedia, Loss aversion