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B. Venkatesh

AN investor I know bought Infosys for Rs 6,000 two years ago and refuses to sell the stock unless the price moves above that level. His action, called loss aversion, is typical of all small investors. What is loss aversion?

Note that the investor is unwilling to sell now even though he knows that the stock could decline further.

He is, thus, willing to take more losses hoping that the stock will go up one day.

Now, suppose the stock was Rs 7,000 a month ago, but has since been falling gradually. The investor is likely to sell the stock, because of the fear that it may fall below Rs 6,000. The reason? He does not want to take losses on the position; smaller returns are better.

The investor is, thus, a risk-seeker when faced with the prospect of losses, but is risk-averse when faced with the prospects of enjoying gains. This phenomenon is called loss aversion.

Kahneman and Tvesky, two Israeli psychologists, discovered this behaviour when conducting an experiment in 1979. They offered the subjects the following options: Choosing between an 80 per cent chance of winning $4,000, and a 20 per cent chance of winning nothing, against a 100 per cent chance of receiving $3,000.

Their subjects chose the 100 per cent chance of wining $3,000. Note that the mathematical expectation of the first choice is higher ($ 4,000 X 0.80 + $ 0 X 0.20= $ 3,200).

Then, the following options were given: 80 per cent chance of losing $ 4,000, and a 20 per cent chance of losing nothing against 100 per cent chance of losing $3,000.

The subjects predominantly chose the first option even though the mathematical expectation of losses was higher ($ -4,000 x 0.80 - $0 X 0.20 = $ -3,200).

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