Are you a victim of loss aversion phenomenon? --- Chandni Burman

Poker players explained to me that there’s a particular moment at which players are extremely vulnerable to an emotional surge.

“I can’t get him and I can’t get over him,” said Ruma, when we caught up over the weekend.

“Oh, I thought you had gotten over that bugger,” I replied.

“Arre nahi, I keep going back to him, even though I know it’s not quite working out between us.”

“These creative types have too many mood swings darling. It is best to stay away from them, that’s the least I can tell you from experience.”

“One day he wants to marry me and the next day he says only weak men get married,” sobbed Ruma.

“Oh. That’s bad,” I sympathised.

“I don’t know what to do. This is getting way too depressing.”

“Hmmm. I think you have become a victim of loss aversion.”

“Loss aversion? Here I am telling you the problems of my life and you come up with this jargon. Tum bhi na!”

“I find this concept of loss aversion really interesting. Have some patience and hear me out. Okay?” I enquired.

“Hmmm. Okay. So tell me. What is this loss aversion?” she asked.

“It is essentially the tendency to hold onto a losing investment or bet.”

“I don’t quite get it.”

“Let me give you an example. You remember Ambar na, my ex?”

“Of course I do. Is he still chasing you?” she asked with a smirk on her face.

“Ha ha. Of course he is. But that is not the point I was trying to make. So Ambar had invested in a few stocks on the basis of some tips that he had got from gujju landlord. “Ekdum teen mahine main double hoga,” the landlord had told him.”

“Oh. And did that happen?”

“Well, it did not double, but it halved. He had bought the stock at a price of Rs45. And three months later the stock was quoting at around Rs24.”

“And then what happened?” she asked.

“He called me, like he always does, when he is in trouble, and told me the entire sob story. After hearing him out, I asked him to sell the stock, given that the prospects of the stock were not looking good.”

“Yeah. That made sense.”

“And then he told me that his plan was to buy more of the same stock. He felt that by buying more he would be able to 
average down the purchase cost. So once the stock price goes up he would be able to make good his losses more quickly.”

“Ah. So what happened?”

“Well the stock kept falling. He kept buying more. The last I checked the price had touched single digits and Ambar still 
hadn’t sold the stock.”

“Oh. That was rather stupid of him.”

“Yes it was.”

“But why this behaviour? Couldn’t he see it’s a losing proposition all the way?”

“He could not. He had become a victim of loss aversion or the tendency to hold onto a losing investment,” I explained.

“But what is the reason behind this?”

“Economists over the years have carried out a lot of research in this area and have concluded that people experience twice as much pain when they face a loss in comparison to the pleasure they experience when they make a gain.

V Raghunathan explains this phenomenon in his book The Corruption Conundrum and Other Paradoxes and Dilemmas. ‘The pleasure of Sensex going up from 10,000 to 20,000 was much less than the pain of its drop from 20,000 to 10,000, wasn’t it? In short then, losses loom larger than profits,’” he writes.”

“That makes sense.”

“ So there are two aspects to the whole thing. One, the inability to sell and cut losses, and two, to keep on buying more in the hope of averaging down the cost. This throwing of good money after bad is referred to as ‘sunk-cost’ fallacy.”

“Yeah, that was obvious.”

“In fact Tim Harford explains this rather well in his new book Adapt in which he talks about top level poker (a card game) players. “Poker players explained to me that there’s a particular moment at which players are extremely vulnerable to an  emotional surge. It’s not when they’ve won a huge pot or when they’ve drawn a  fantastic hand. It’s when they’ve just lost a lot of money through bad luck or bad  strategy. The loss can nudge a player going ‘on tilt’ —  making overly aggressive bets in an effort to win back what he strongly feels is still his money. The brain refuses to register that the money has gone. Acknowledging the loss and recalculating one’s strategy would be the right thing to do, but that is too painful,” writes Harford.”

“That explains it, I guess.”

“Yes. The term was coined by psychologists Daniel Kahneman and Amos Tversky. As they say, ‘A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.’”

“So the tendency is to catch a falling knife?”

“Yes Mam. In fact there is another beautiful example in the book A Mathematician Plays the Stock Market written by John Allen Paulos. Paulos shares his experience of investing in a stock called WorldCom, which at a certain point of time was the second largest telecom company in the US. In 2002, it came to light that the company was essentially boosting its earnings by resorting to accounting fraud. The stock price had started to fall even before that, when investors realised that analysts following the sectors had been writing trumped up reports on the kind of earnings US telecom companies would make in the future. The sector had built up huge overcapacity over the years and did not have much pricing power.”

“So what happened with Paulos?”

“As he writes, ‘By late summer 2000, WorldCom had fallen to $30 per share, inciting me to buy more. By this I don’t mean that there wasn’t a rational basis for investing in WorldCom stock...If you didn’t look too closely at the problems of overcapacity and the long distance phone companies’ declining revenue streams, you could find reasons to keep buying...Of course, for every facile invitation I extended myself to ‘average down,’ I ignored an equally facile warning about not attempting to ‘catch a falling knife.’”

“And he kept buying more stock!”

“Yes. In fact as he points out, ‘I kept telling myself that I’d incurred only paper losses and had lost nothing real unless I sold. The stock would come back, and if I didn’t sell, I couldn’t lose.’”

“Makes tremendous sense Chandni ji. But why have you been telling me all this?” she asked with tremendous concern.

“Oh, I thought it would be rather obvious by now. Isn’t it?”

“No. Today my brain is not working. I am missing him big time.”

“Hah. Well, you know the relationship is not working, but you don’t want to get out of it and cut your losses, because as long as you keep holding onto it, you still feel there is a chance. It might just work out is what you have been telling yourself. You are ‘averse’ to coming out of the relationship and converting your so called ‘paper’ loss into a ‘real’ loss.”

“Wo subah kabhi to aayegi!” remarked Ruma rather philosophically not wanting to get the point.

— The writer works in the financial services industry and can be reached at chandniburman@yahoo.com. Views are personal