Loss Aversion

Decision-making is a complex activity. Decision-making can be defined as the process of choosing a particular alternative from a number of alternatives. Choosing from the alternatives is the most crucial challenge faced by the investors is in the area of investment. The principal objective of an investment is to make money. Investment decision making involves the process of identifying, evaluating, and selecting among projects that are likely to have a significant impact on the expected future income. Every investor differs from others in economic background, educational attainment level, age, race and sex. To face this challenge, one needs better insight, and understanding of human nature in the existing global perspective, plus development of fine skills and ability to get best out of investments.

Loss aversion is an important psychological concept which is receiving increasing attention in economic analysis. It has first been proposed by Kahneman and Tversky (1979) in the framework of prospect theory. This particular effect of behavioral economics explains why people are more motivated to avoid a loss than to acquire a similar gain. Itis the wiring that makes us feel more depressed at the loss of Rs. 100 than elated at winning the same amount of money. In a nutshell “Loss aversion shows that losses loom larger than gains; that is, individuals weigh losses more heavily than the gains.”

What does loss aversion mean for investors in the course of portfolio planning? Investors seek to achieve a certain level of return. They like it when they earn positive returns, but they hate it even more when the returns go negative. What causes this systematic asymmetry between an investor’s response to gain and loss—and how investors should deal with it when planning their investment strategies? Based on the asset’s return and volatility characteristics, how much could the investor potentially stand to lose, in actual monetary terms? It is when investors are confronted with the reality of cold hard cash that loss aversion sets in. By understanding the implications of large losses, investors can decide how much risk they are willing to potentially sustain in pursuit of their long term return objectives.

Loss aversion also explains one of the most common investing mistakes i.e. investors evaluating their stock portfolio are most likely to sell stocks that have increased in value. Unfortunately, this means that they end up holding on to their depreciating stocks. Over the long term, this strategy is exceedingly foolish, since it ultimately leads to a portfolio composed entirely of shares that are losing money. 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.

This research will be an attempt to understand the behavior of individual investors in Madhya Pradesh as to how investors decide upon their portfolio for the investment. How far the investors are affected by the principle of Loss Aversion?