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Loss Aversion In Investing

Loss Aversion: Buy, Sell or Hold?

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Don’t Listen To Me, But Please, Hear Me Out: # 40

Shaheeda Abdul Kader, Sep 2 2021

Cartoon Cover Credit: Boston.com

Loss Aversion: Buy, Sell or Hold?

When you look at investing, do you say, “Wow! Look at how much money I can make!” or do you say, “Ooh! I could potentially lose a lot of money.”

Are you loss-averse or risk-averse or both or neither? Today, I want to tell you about ‘Loss Aversion’ and ‘Risk Aversion’.

So, I have this rather cocky but brilliant friend, let’s call him Fred, who does well for himself trading and investing in the stock market. Fred has been teasing me about certain stocks I hold, encouraging me to sell them. You see, there have been some rather negative movements in the stock price of certain companies I love like Amazon (AMZN) and Netflix (NFLX).

Trouble is that we are both very rational. So, it was hard for either of us to concede to the other’s point of view. So, who is right? Or in this case, righter than the other?

One thing I know about me is that I have no problem reviewing my position and even admitting a mistake or changing my stance. Hence, I asked myself, “Am I being truly cold and rational or am I falling prey to ‘Loss Aversion’?”

What is Loss Aversion?

Why does losing $100 feel a lot worse than winning $100? This is Loss Aversion. All of us feel this. Psychologists Daniel Kahneman and Amos Tversky first illustrated this behavior and coined the term Loss Aversion in 1979. The experiment they conducted was simple. 

The pain of losing is twice the pleasure of winning.

If I challenged you to a coin-toss game in which you could get $10 if you won or lose $10 if I won, would you play? Most people would not accept this challenge. What if I said, you get $12 if you win but only pay $10 if you lose, would you take the challenge then? How much would you have to win for you to accept the challenge? In most cases, people would accept the challenge only if they could win twice as much as they could lose. In other words, people needed the chance to win $20 and lose only $10.  

The pain of losing is twice the pleasure of winning. This is Loss Aversion.

The video below is a great illustration of people’s behavior and loss aversion. 

So what does all this have to do with my cocky friend Fred, investing and me?

Loss Aversion In Investing

Sometimes we may hold on to a stock that is declining in price because we convince ourselves that it is not a real loss because it is only on paper or a screen on your phone. Once we sell the stock, then we must accept the real cash loss in our investment, and this is very painful. So, we want to delay this pain for as long as possible.

Example 1, you bought 100 shares of Stock A at $10 a piece a year ago. Today, the price is $8. Your unrealized loss is 100*(8-10) = -$200 or -20%. You don’t want to sell because you think the stock will go up in price. You most certainly want to avoid the pain of losing $200.

The problem is that if there are fundamental reasons for the falling stock price, holding on to the stock could potentially incur even more losses. The stock price may fall further. I’ve fallen pray to this many times and even wrote about it here.

You are also missing out on the opportunity of investing the money from selling the stock in a better company. You are losing time and money to invest in a better asset that may help you recuperate your loss as well as provide better returns. This is called the opportunity cost. 

The flip side is sometimes we may sell a great stock too soon after seeing some gains. We are worried of losing the gains just in case the price falls.

Example 2: you bought 100 shares of Stock B at $10 a piece a year ago. After 6 months, the stock price climbed to $12 per share. You are looking at an unrealized gain of 20% or $200. However, you’re worried that the price may drop to $11 and reduce your gains. You want to avoid the pain of losing your gains, so you quickly sell. If the company is fundamentally strong and has great outlook, it is possible that the stock price could have risen to $20 but by selling the stock too soon, you left money on the table. 

Sometimes a Bird in your hand may not be better than the two in the bush. 

Loss Aversion and Risk Aversion are not the same. If you are risk averse, you may invest more in stable investment grade bonds and less in equities. However, loss aversion can impact even those who are happy to take on a lot of risk. 

Two quotes from Lance Armstrong illustrates the difference between Loss Aversion and Risk Eversion.

“If you worried about falling off the bike, you’d never get on.” 
― Lance Armstrong

This is about risk aversion.

“I like to win, but more than anything, I can’t stand this idea of losing. Because to me, losing means death.”

This is Loss Aversion. Armstrong was so averse to losing that he eventually ended his career in disgrace. He was willing to risk everything to not lose.

In investments too, if we let our loss aversion take control over our rational selves, we could end up making very costly mistakes.

So lets get back to my friend Fred.

Right Said Fred

Table 1: Stock Price for AMZN & NFLX, Sep 2021

Two of my favorite stocks in my portfolio are Amazon ($AMZN) and Netflix ($NFLX). Unfortunately, both have had a rather lackluster and even dismal year. The S&P 500 ETF ($SPY) is up 22.5% YTD, whereas AMZN returned 6.4% and NFLX 7.65% as on Sep 1 2021.

Amazon Stock Performance in 2021

In Table 1 we can see that AMZN hit an all-time high (ATH) of $3,731 on 8th July and then had a rather steep fall on July 30 to $3,327 before dropping even further to $3,187 on 19th of August. Fred tried to convince me several times between July 30 and now to sell Amazon. He believes that AMZN would not beat the market and so I should cut and run. 

When AMZN fell to $3,187 its returns for the year had dropped to -2.1% for the year. Indeed, this is rather horrible compared to the overall market. However, I did not sell. Is it because I am suffering from Loss Aversion as illustrated in example 1? 

I do not believe so. Firstly, I have a healthy profit in AMZN now as I am long-term investor. Secondly, AMZN is fundamentally a very strong company. Its earnings call disappointed analysts not because AMZN didn’t grow, but it didn’t grow to the extent analysts expected. To me, it is silly to abandon a great company just because it didn’t meet expectation in 1 quarter while growing aggressively. AMZN did provide a softer outlook for the 3rd quarter as well. So, perhaps it won’t grow as much this year. 

So then, I am paying the opportunity cost of not selling and investing the proceeds in a better, high growth stock, right? Well, as you can see from table 1, AMZN returned 9% in 13 days from its low of $3,187 to yesterday (Sep 1) closing price of $3,479. It is extremely hard to time the market. I am a long-term investor. So, for me dips in great companies are buying opportunities.

Netflix Stock Performance in 2021

The story is similar in the case of NFLX as well. NFLX has also lagged SPY and has returned only 7.65% YTD. However, from the lows of this year to yesterday’s closing, NFLX returned 21% in 86 days or less than 3 months. NFLX does have a lot of competition from other streaming giants such as Disney, HBO, HULU etc., but I like this stock. 

I probably am responding with some loss aversion behavior, but, for now fundamentally, I like both stocks and so I will hang on to them.

The other reason I can afford to hold on to them is because I do not need the cash proceeds from the sale to invest in new stocks. I have some liquidity to deploy for other opportunities. So, my decision is not impeding me from taking advantage of better opportunities. 

If you do not have cash in hand or your investment goals are different, then you may have to react differently than I have. 

What Are The Other Opportunities?

Fred is very bullish on Alibaba (BABA). He said I should sell AMZN and buy BABA. Should I buy BABA?

There are 4 C’s of investing.

  1. Company Risk
  2. Category Risk
  3. Currency Risk
  4. Country Risk

Company Risk

BABA passes with flying colours on company risk. Baba is fundamentally a great company. It has had 40% revenue growth YOY. It is trading at P/B (Price To Book) of 3.12, EV/Sales of 2.83 and a forward P/E of 21.14. This is a great value stock.

Category Risk

e-Commerce is growing and so as a category also the risk level is good.

Currency Risk

The CNY (Chinese Yuan Renmimbi) is very strong and stable, so currency risk is also acceptable. As foreigners, we would buy the stock from NASDAQ for example and in USD, so currency risk is acceptable.

Country Risk

But when we look at Country Risk, there is literally a massive red flag. Chinese regulators have been cracking down on billionaires as well as large powerful tech companies. DIDI, the Chinese ride sharing app went live on NASDAQ with much fanfare on June 30th. Unfortunately, within a week of the IPO, Chinese regulators cracked down on DIDI and the stock has lost nearly 50% from all time highs. Investors have launched a massive class action lawsuit against DIDI because of these losses.

Alibaba, Tencent, JD, Byte Dance (owner of TikTok), have all come under Chinese regulatory ire. Both the companies and investors have paid dearly. 

Baba stock was down 50% from its all time high of $309 on 19th October 2020. On Aug 20th of this year, it had dropped to a low of $157. Fred along with many other analysts said this was a great time to buy BABA.

However, in the case of BABA, in my humble opinion, the loss aversion is not that the stock may nose-dive another 10% or even 50%. There is a real risk that the stock may go to zero. I’m risk-averse to BABA because I cannot reasonably mitigate the country risk.

Why? Because BABA that we buy on Nasdaq is NOT the real company shares of Alibaba in China. We are buying the stock in a VIE (Variable Interest Entity). VIE’s are usually incorporated in a tax haven like the Caymen Islands. VIE’s have certain contracts with the actual company in China. These contracts give VIE’s controlling rights to the company. If the Chinese regulators decide that the contracts with these VIE’s are illegal, then essentially all investors in BABA in NASDAQ will lost their entire investments. Bloomberg’s Matt Levine wrote an excellent piece on VIE’s you can read here.

China has already disallowed VIE’s in the highly profitable private tutoring companies in China. 

So there is PRECEDENT for such a move. This is why I am reluctant to invest heavily in BABA. This is not Loss Aversion. To me this is sound risk management. Every investor takes calculated risks.

Nonetheless, it is worth noting that, as on Sep 1, BABA was up 11% from its all time lows of $157. I dipped my toes in and took a tiny position in BABA a few days ago. The upside potential is significant. Time will tell if my concerns were right or Fred was more right.

Final Thoughts

There is evolutionary reasons for Loss Aversion.

For an organism operating close to the edge of survival, the loss of a day’s food could cause death, whereas the gain of an extra day’s food would not necessarily cause an extra day of life.

Idea To Value

However, as investors we can minimize the opportunity costs of loss aversion by reframing the decision you have to make. Instead of asking if you should sell the stock, do the following exercise.

Imagine that you mistakenly sold the stock. Now you have cash from the sale in your account. You can go back and buy the same stock with that cash or buy something else. If you’d buy the same stock, then by all means don’t sell. Hold on.

If on the other hand you don’t find yourself in a hurry to buy back the same stock, then go ahead and sell it.

Finally, whatever you decide, make sure your decision fits with your risk-profile and investment goals.

In my case, my portfolio is diversified and so long as my returns are on par or better than SPY, I’m happy.

If you want to learn more about investing in the stock market, may I suggest you start here?

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I usually blog about investing in the stock market. If you would like help on how to budget, save or invest more, please feel free to reach me, on Twitter @saq3 or LinkedIn @Shaheeda Abdul Kader, or leave a message at say@shaheedasays.com. I’d be happy to offer you my services. Please do check my other blogs here.

Disclaimer:

I am NOT a certified broker or financial advisor. Please DO NOT make investment decisions based solely on my blogs. My intention is to show you how to research stocks or funds for yourself . I hope you will be empowered and knowledgeable to do your own investigations and invest with confidence. It is best to consult with your broker or advisor if you have questions. You can also reach me, and I’ll do my best to help you with your queries.

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Shaheeda Abdul Kader

After 25 years of working for corporations, being an entrepreneur and managing investments for my family, I now want to help others find their financial freedom