Loss Aversion

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Loss aversion bias is based on the theory that the pain caused by losing Rs 50000 is greater than the joy that comes from gaining Rs 50000. In other words fear is a more powerful motivator than greed.

Risks of Loss Aversion

Traders who are completely averse to losses are most likely to hold onto losing positions in hopes that there will be a reversal. If it does not ocurr, the trader will end up with a much larger loss. A traders should be able to accept short-term losses and move onto other more-profitable trades. Holding onto losing positions jeopardizes the stability of a portfolio because the trader will not only incur more severe losses but this behaviour will also keep him/her out of better investments.

Overcoming Loss Aversion

The best way to overcome a loss aversion bias is to trade with real stop-loss orders. Many traders tell themselves that they will trade with a mental stop-loss that they think about and promise themselves they will act on if the stock ever reaches it. All too often, however, traders fail to act on their mental stop-losses. They let their emotions get in the way and they start rationalizing their choice to stay in the trade until it turns around.