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How Thinking
Affects Investing

Loss Aversion

Let's say you are in a situation where you must choose one of the following: you can either avoid losing $1,000, or you can gain $1,000. Logically, these two choices are equivalent, so it shouldn't matter which one you pick. Nevertheless, because of a cognitive bias we call LOSS AVERSION, most people tend to select the first choice. Why? Because, for most human beings, the satisfaction that comes from avoiding a loss is much stronger than the satisfaction that comes from acquiring a similar gain.

The fact is, every successful investor will have times when he or she is faced with the need to accept a loss and move on. The decision should be made rationally, without emotion and without unnecessary delay.

This is why loss aversion causes us so much trouble. Because we suffer disproportionately from losses, the fear of a loss has more power over our behavior than does the prospect of a gain. As a result, we often find ourselves maneuvering to avoid the internal discomfort that comes with a loss even when what we are doing is, rationally, not in our best interest. Moreover, because this all happens beyond our conscious awareness, we invariably fool ourselves into thinking we are making the best possible decisions, when we are actually acting irrationally.

As an investor, you can expect loss aversion to manifest itself in three important ways, each of which is a cognitive bias in its own right:

  • Endowment Effect
  • Disposition Effect
  • Sunk-cost Effect

My goal is to help you become aware of these specific cognitive biases, and to show you how to avoid them when you make investment decisions. In the long run, such insight into your emotional nature will pay off handsomely.

Harley's Rule of Investing #3

The most expensive tuition is what you end up
paying the market to teach you how to take a loss.

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