3. Loss Aversion

Let’s play a simple game – we’ll flip a coin, and if it turns up heads, you win $110. If it turns up tails, you lose $100.

Will you take the gamble?

Logically, it is a good gamble to take, simply because the expected value is more than 1. That is, given the 50-50 chance of winning or losing, you stand to win more than you lose, $110 vs $100. 

However, most people instinctively choose not to take the gamble. Why?

Because of loss aversion. In their minds, the discomfort of possibly losing $100 outweighs the happiness of possibly winning $110.

It is important to note that loss aversion isn’t a cognitive bias that is fixed at a certain level, like $110, for all individuals. Everyone will have a different number at which their decision changes.

The way to see this for yourself is to ask – instead of a chance to win $110, would you take the coin toss for a chance to win $120? If not, what about $150? How about $200?

In addition, the relationship between psychological distress from losses vs happiness from gains also isn’t linear, and is more like an “S” curve (sigmoid function). At any one point in time, every individual will have their own uniquely shaped S curve, reflecting their own preference for risk and reward.

That being said, as traders, it isn’t as important to figure out our own S curves as it is to understand how loss aversion acts against us when we are making trading decisions.

A good example of this is when it prevents us from taking trades that have the potential to be profitable.

To be continued…