Loss aversion is the first one I discuss because it is fundamental in the development of Behavioral Economics, as demonstrated in a landmark study by Daniel Kahneman and Amos Trevsky in March 1979. If you want to unleash the geek in you, go ahead and check out Prospect Theory: An Analysis of Decision Under Risk. Kahneman won the Nobel prize in 2002 for this study; unfortunately, his co-author, Trevsky, had already died six years prior.
Let Mak and Emong show you
To avoid nose bleed, let’s allow Makatwirang Mak and Emotional Emong to show us how this Behavioral Economics principle works.
Mak and Emong are ready to invest in the stock market. They pick Blue Chip Company A, a conglomerate that has been in existence for over a hundred years that remains financially sound. They both purchase 100 shares at Php100.00 per share, for a total investment cost of Php10,000.00 each.
After one month, Blue-chip Company A stock price goes up to Php110.00, earning them 10% return. However, two weeks later, it went down by Php10.00 per share, bringing them to their original purchase price. To understand the principle of loss aversion, let us look at the Pleasure and Pain Graphs of Mak and Emong.
Above is Mak’s Pleasure and Pain Graph. When the stock price went up by Php10.00 per share, Mak earned Php 1,000.00 and felt 1,000 pleasure points. He tells his family and friends how he is making 10% return on his stock investment. He feels like he gained 1,000 pogi points!
When his investment went down by Php10.00 per share, he lost Php1,000.00 and felt 1,000 ouch points as shown in the graph. He feels he is back to his original pogi rating.
Rational as he is, Makatwirang Mak felt the impact of the gain in the same way that he felt the impact of the loss, no more, no less.
Let’s look at how Emong felt with the same price movements of his investment.
Above is Emong’s Pleasure and Pain Graph. When the stock price went up by Php10.00 per share, Emong earned Php 1,000.00 and felt 1,000 pleasure points. He tells his family and friends how happy he is making 10% return on his stock investment. He feels like he gained 1,000 pogi points!
When the stock price went down by Php10.00 per share, he lost Php1,000.00 on his investmen, and can you guess how many pain points he felt? Not 1,000 but at least 2,000 pain points! It’s as if he lost Php2,000.00. He didn’t feel being back to his original pogi rating, but down by at least 2,000 pangit points! Ugh! He felt so awful saying, “I should have sold when it was Php110.00 per share!”
The principle of Loss Aversion states that losses loom larger than gains. We feel the impact of a loss at least twice as much as that of a gain.
So my dear reader, do you see what’s happening here? I hope you can honestly figure out your own rating on this behavioral bias. When it comes to Loss Aversion, how much of you is Makatwirang Mak and how much is Emotional Emong? Go ahead, rate yourself. This is a good beginning for you to honestly size up yourself, then you can come up with a design that will allow you to overcome excessive loss aversion for a healthy and peaceful investing.
To know more about this, you may check out the other examples in FQ Book 2.
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This article is also published in Philstar.