There is a term called loss aversion which means that losses have a higher psychological impact than making financial gains. When a person loses $1,000, they feel more pain than the joy of gaining $1,000. In this article we discuss this concept in further and the impact it has on your share portfolio.

Definition:

In trading psychology, humans feel more pain when they lose money compared to when they win money. Fear is a more dominant emotion than greed. This causes investors to behave more emotionally when dealing with losses. They will be attached to the losses in their portfolio and not want to sell as the pain of losing so much money would cause a great deal of discomfort. On the contrary, if the investor was to make a profit of the amount of money, the emotional jubilation of the win would not be as intense as the angst associated with the same amount as a loss. That is, the angst of a $10,000 loss is more stronger than the joy of a $10,000 win.

Consequences:

This mindset can cause an investor to hold on to a losing trade longer. Investors may hold on to a stock hoping that they will make their money back eventually. This strategy may backfire if the company never recovers and the share price continues to decline. If it keeps declining for prolonged periods of time, then the company has a good chance of becoming bankrupt or delisted. In this case, the investor would have lost their entire investment. By being averse to selling at a loss, an investor can risk losing the entire capital in the share holding.

Strategies

It is important to have a plan at the start at the trade and identify the amount of capital the investor is willing to lose. If there is plan in place, the investor can become less emotional about selling at a loss.  Stop losses can be placed on trading platforms so the position is automatically sold if the share price hits that level.

Also, there is an opportunity cost associated with locking in your capital with a stock that continues to fall. You could be using your capital to invest in other stocks that are rising.

Lauren Hua is a private client adviser at Fairmont Equities.

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