The first stock I ever bought was Cisco Systems, in early 2000. It was the height of the dot-com bubble, and Cisco, whose share price had just passed $80, was about to become the most valuable company in the world
. Needless to say, my investment didn't turn out so well. After the dot-com bubble burst, later that year, Cisco stock went into a freefall and started trading in the teens.
But here's the strange part of the story: I still own those Cisco shares, which are still trading in the teens. Even though I know the share price will never return to its dot-com peak (at least in my lifetime), I can't bring myself to sell. I'm going to be stuck with Cisco stock for the rest of my life.
Why am I behaving so irrationally? Why do I refuse to sell this losing stock? It turns out that I've fallen victim to a very simple flaw that's rooted in the emotional brain. This mental defect — its technical name is loss aversion — was first discovered by Daniel Kahneman and Amos Tversky in the late 1970s.i Kahneman and Tversky stumbled upon loss aversion after giving their students a simple survey, which asked whether or not they would accept a variety of different bets. The psychologists noticed that, when people were offered a gamble on the toss of a coin in which they might lose $20, they demanded an average payoff of at least $40 if they won. The pain of a loss was approximately twice as potent as the pleasure generated by a gain. Furthermore, our decisions seemed to be determined by these feelings. As Kahneman and Tversky put it, "In human decision making, losses loom larger than gains."
But loss aversion isn't just about coin flips. Consider this scenario:
The U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows: If program A is adopted, 200 people will be saved. If program B is adopted, there is a one-third probability that 600 people will be saved and a two-thirds probability that no people will be saved. Which of the two programs would you favor?
When this question was put to a large sample of physicians, 72 percent chose option A, the safe-and-sure strategy, and only 28 percent chose program B, the risky strategy. In other words, physicians would rather save a certain number of people for sure than risk the possibility that everyone might die. But what about this scenario:
The U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows: If program C is adopted, 400 people will die. If program D is adopted, there is a one-third probability that nobody will die and a two-thirds probability that 600 people will die. Which of the two programs would you favor?
When the scenario was described in terms of deaths instead of survivors, physicians reversed their previous decision. Only 22 percent voted for option C, while 78 percent of them opted for option D, the risky strategy.
Of course, this is a ridiculous shift in preference. The two different questions examine identical dilemmas; saving one third of the population is the same as losing two thirds. And yet, doctors reacted very differently depending on how the question was framed. When the possible outcomes were stated in terms of deaths — this is the "loss frame" — physicians were suddenly eager to take chances. They were so determined to avoid any alternative associated with a loss that they were willing to risk losing everything. That's how much we hate losses.
Loss aversion is now recognized as a potent mental habit, with widespread implications. It's an especially relevant bias in times of loss, when house prices are falling and the Dow is sinking and companies everywhere are cutting back. For instance, loss aversion helps to explains one of the most common investing mistakes: investors evaluating their stock portfolio are most likely to sell stocks that have increased in value.ii Unfortunately, this means that they end up holding on to their depreciating stocks, like those shares of Cisco or Citibank or General Motors. Over the long term, this strategy is exceedingly foolish, since it ultimately leads to a portfolio composed entirely of shares that are losing money. (A study by Terrance Odean, an economist at UC-Berkeley, found that the stocks investors sold outperformed the stocks they didn't sell by 3.4 percent). Even professional money managers are vulnerable to this bias, and tend to hold losing stocks twice as long as winning stocks. Why do investors do this? Because they are afraid to take a loss — it feels bad — and selling shares that have decreased in value makes the loss tangible. We try to postpone the pain for as long as possible. The end result is more losses.
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i "This mental defect": Kahneman, Daniel, and Amos Tversky. 1979. Prospect Theory: An Analysis of Decision under Risk. Econometrica 47: 263-291.
ii "Loss aversion also": Odean, Terrance. 1998. Are Investors Reluctant to Realize Their Losses? Journal of Finance, Vol. LIII, No. 5: 1775-1798.