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My wife and I were thumbing through our first quarter financial statements recently and like many people experienced a rough first quarter. In our 401(k) accounts, we each have our share of investments that are in the red for the year. For my wife, one of those investments is a mutual fund that she just bought recently. She’s a bit of an emotional investor and like a lot of people who have experienced an immediate loss in one of their investments, she’s ready to sell. What she said to me was representative of what I think too many people in this situation feel – “Once it gets back to what I paid for it, I’m going to sell it.”

So let me get this straight. She doesn’t like the investment, doesn’t want to be in it, but is willing to hang on to it long enough to get back to the point where she bought in (which could take weeks, years, or may never even get back to the original purchase price). Why would she do this?

It’s what psychologists refer to as “loss aversion”. The concept is that individuals will much more strongly prefer to avoid losses than achieve gains. In the mind of the investor in this circumstance, selling at a loss is the equivalent of admitting a mistake and for many admitting they made a mistake is a difficult thing to do. For my wife, the aversion to loss is so strong that she would rather hold on to an investment that she dislikes (and could consequently be accepting inferior returns for) than sell and move that money to a different investment.

Traditional finance theory would argue that my wife should base her decisions in the context of our entire portfolio as well as our current circumstances and goals and ignore cognitive biases such as loss aversion. After all, if the fund she wants to sell is still a logical fit in our overall portfolio and is still considered a quality investment, why wouldn’t she contemplate hanging on to it despite its recent losses?

The answer, of course, is that people are not logical. They make emotional decisions that can potentially derail a good long-term plan. It’s only when people can understand and overcome these biases that they truly can become better investors.

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Tags: loss aversion