Dr. Doug's Blog

Loss Aversion - Is it really 2 to 1?

Feb. 6, 2013 Comments

In the behavioral finance world or behavioral economics or psychology economy (whichever label you prefer), the concept of Loss Aversion is well known and accepted.

Credit is given to Amos Tversky and Daniel Kahneman for convincingly demonstrating that human decision making, when it comes to money, is inherently flawed.

Among many other things, one aspect of their research showed that people acted differently towards profits than they did towards losses.

More specifically, that for every $1.00 a person losses, they feel the need to make $2.00 to equally offset the emotion induced by the loss.

As a result, the famous term "loss aversion" and 2 to 1 ratio were born.

But is it really 2 to 1?

More importantly, is the ratio 2 to 1 among elite performers?

I do not believe this is the case. Let's look at the Lakers, Kobe Bryant, for example.

Kobe has been in the NBA for 16 years and has an average free throw percentage of .838 (83.8%)

If we put him on the line and asked him to shoot 10 free throws, what would his loss aversion ratio be?

If he misses the first basket, how "bad" do you think he would feel? And if he makes the second and third basket, how "good" do you think he would feel? 

Framed, this way, you can see how his “good” feeling may not be so high; yet his “bad” feeling would be extremely high and I believe it would take more than making 2 baskets in a row to offset the "bad" feeling he got from missing his first one.

In fact, it should take making 8-9 baskets in a row to offset the one he missed. Why? Because as a professional basketball player with career average 83.8% free throw percentage, he EXPECTS to make many more shots than he misses - exactly 8.38 out of 10.

So what about the elite portfolio manager?

Again, he has a proven track record of success and profitability (just like Kobe) so he EXPECTS to make money over time.

This is why I don’t believe his loss aversion ratio is 2 to 1 like the average person who was part of Kahneman and Tversky’s research.

Instead, I have found that it is greater than 5 to 1 and even more interesting (as my graph above shows) this ratio increase at an increasing rate the longer he goes without making money.

As a trading psychology coach, this is critical for me and my client to understand so that we can take proactive measures in preventing him from losing objectivity in his trading process and falling prey to destructive trading behaviors like trading for revenge, over-sizing trades, rushing into trades and not sticking to stop losses.

Trade well,

Dr. Doug

Comments

Recent Video