What it means
Behavioural economists study how real people make financial decisions, rather than how a perfectly rational person would. A central finding, from prospect theory, is that people judge outcomes as gains and losses relative to a reference point, often the price they paid.
Losses from that point tend to feel considerably stronger than gains of the same size, often estimated at roughly twice as strong. This has practical effects.
An investor who bought a share at $50 and sees it fall to $35 may refuse to sell, hoping to get back to $50, even though the decision should be based on its future prospects rather than the purchase price. Selling would make the loss real, which feels worse than keeping it on paper.
Loss psychology also drives the opposite behaviour. People often sell winning investments too early to lock in the pleasant feeling of a gain, a pattern called the disposition effect.
They may also take big risks to avoid a certain loss, for example doubling down on a failing project to try to break even. In business settings, the same instinct appears as the sunk cost fallacy (continuing a project because of money already spent, not because of future returns).
Managers who have invested heavily in a product may persist long after the evidence turns negative. Awareness helps.
Rules such as predefined exit points, regular portfolio reviews, asking "would I buy this today at this price?" and sharing decisions with an independent adviser reduce the pull of emotion. Framing results over longer periods also makes losses feel less sharp.
Financial firms also design products around these instincts, for better or worse. Automatic rebalancing, default savings rates and stop-loss rules protect clients from emotional reactions, while heavily promoted trading apps can encourage constant checking, which tends to make losses feel more frequent.
Understanding your own reactions is as valuable as understanding the market.
In practice
Real-world examples.
Example
An investor refuses to sell a share that has fallen from $80 to $55, although she would not buy it at that price today. She says she will sell when it gets back to $80, which anchors her decision to a price the market has no obligation to revisit.
Example
A project manager has spent $2,000,000 on a software system that is clearly failing. He asks for another $500,000 because stopping now would mean admitting the whole amount was wasted. A colleague points out that the $2,000,000 is gone either way and that only future costs and benefits should drive the decision.
Example
A small business owner sells a profitable investment after a 6% gain to feel safe, but holds a struggling one for years, ending up with a portfolio dominated by losers. Over several years, his results trail those of a friend who simply holds a broad index fund.
Formula
Calculation
Perceived value of a loss = Loss amount x Loss aversion coefficient
Researchers have often estimated the loss aversion coefficient at around 2, although it varies between people and situations. Suppose an investor gains $1,000 on one holding and loses $1,000 on another.
Perceived value of the gain = $1,000 x 1 = +$1,000 of satisfaction.
Perceived value of the loss = $1,000 x 2 = $2,000 of dissatisfaction, felt as -$2,000.
Net feeling = +$1,000 - $2,000 = -$1,000, even though the actual net result is $0.
This is why a portfolio that is flat in dollars can still feel like a losing one.Case study
Seen in the real world.
Calder and Rowe are a fictional couple in an illustrative story, and together they held ten shares. They sold three winners at modest gains to lock in profits and held onto three losers, down 30% to 40%, saying they would wait for them to recover.
Over the next two years the winners they sold continued to rise by an average of 25%, while the losers they kept fell a further 15%. Their portfolio underperformed a simple index fund by several percentage points a year.
After seeing a financial planner, they introduced a rule: review each holding every quarter and sell any position that they would not buy again at the current price. In this illustrative story the rule did not guarantee profit, but it removed the emotional bias from the decision.
Watch out
Common mistakes.
- Using the purchase price as the only reference point for deciding whether to sell, when the future outlook is what matters.
- Taking larger risks to try to recover a loss quickly, which can deepen the damage.
- Believing that only inexperienced investors are affected, when research shows professionals also show loss aversion.
Questions
People also ask.
What is loss aversion?
It is the tendency for losses to feel more painful than gains of the same size feel pleasant.
What is the disposition effect?
It is the habit of selling winners too soon and holding losers too long, driven by the wish to avoid realising a loss.
How can I reduce its influence?
Set rules in advance, review holdings on a schedule, focus on future prospects, and discuss large decisions with someone independent.
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