Opinion – Grain in Grain: Understand if you are under the effect of loss aversion bias in your portfolio

Have you ever needed to make a redemption and preferred to sell the position at a profit rather than the position at a loss? If you’ve ever experienced this, know that you may be under the influence of the behavioral bias of loss aversion. I explain below what it is and how to try to avoid it.

Loss aversion bias was initially studied by Nobel laureate in economics Daniel Kahneman and his co-author Amos Tversky. Under the effect of this behavioral bias, investors tend to prefer to avoid losses to obtain gains of similar intensity.

In other words, investors tend to feel more pain in selling a position with a 10% loss than they are satisfied when selling a position with a positive 10% return.

This ends up leading investors to prefer not to exchange a position where they lose 10% for another asset that is more likely to recover the loss.

Also, when they need to make a rescue, they prefer to sell a winning position that has a higher chance of an upside than selling a losing position that has a lower chance of an upside.

Even Warren Buffett, who is the most successful investor in the world, has repeatedly sold positions at a loss. During the 2020 pandemic, amidst several criticisms, Buffett sold his holdings in airlines taking losses of up to 50%.

But are you being influenced by this behavioral bias with any of your investments?

If you’ve never sold a position at a loss, you either have a very conservative portfolio, or you do suffer from the behavioral loss aversion bias.

It is very difficult to assume that one is under the influence of a behavioral bias. I’ve seen investors argue about taxes, transaction costs, and other excuses to justify not taking losses.

Obviously, it is necessary to evaluate the tax and cost issue. And this assessment is simple because it is quantitative. Just do the calculation considering these expenses.

In the case of taxes, currently, the benefit is even greater to sell a losing position first, as I have written here in the past. Most financial institutions automatically accumulate tax losses and offset profits from these losses in order to minimize taxes.

The change in the economic scenario in recent months is undeniable. For example, in the case of inflation. We are experiencing an unexpected global inflation scenario, which is worsening due to recent events. The interest rate and growth landscape in the world is also changing rapidly.

Your portfolio needs to be evaluated under this new scenario and, thus, eventually, it may be necessary to exchange some losing position.

It is important to mention that it is not because you have a position in the portfolio, whose performance did not correspond to expectations, that you need to change.

When the scenario changes, your wallet may eventually change. Be careful not to get stuck in the past. Remember, your portfolio will earn for what the assets provide in return and not for its past behavior.

To avoid falling into loss aversion bias, always do the following exercise.

Whenever you need funds and are going to redeem, consider that your portfolio is made up of money only. Then decide which assets you would buy. It is exactly those that you would not apply at this time that you must rescue.

The same exercise can be done when the economic scenario changes. Consider that instead of assets you only have money. Now decide what you would do without the bias of already owning an asset. Possibly, the resulting portfolio will be different from what you already have. This may be an indication that the portfolio should adapt to the new scenario.

Michael Viriato is an investment advisor and founding partner of Investor’s House

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