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Learning Your Behavior: The Loss Aversion Theory.

12 Nov 2019

Trading in the stock markets or dealing in any aspect of your life which requires you to bet on something, is an activity which is majorly guided by your behavior and your choices. Behavior in turn is decided by your emotions and your outlook towards the world. There are many people who can easily bet on something without getting emotional and contemplative about the gains/ losses. While there are people who are deeply affected by losses and extremely joyous on profits.

The behavior finance branch of studies is a study of the psychology of an average human being on these various aspects of wins and losses. Researchers over the years have done extensive research on how people react to certain situations and why it happens so.

Among this theory is one such finding titled as ‘Loss Aversion theory’. We will explain this as well as others in this post.

Consider this: You have placed two trades in the stock market and one of them is giving you a gain of Rs. 200 whereas in the second trade you are facing a loss of Rs. 200. What should be your ideal reaction to this? Being neural right? Since the trades are negating each other’s effects on your account and your cash.

However, it is observed by behavior finance researchers, that people focus more on the losses and feel sad about it, even if there has been an equal gain.

This is the ‘Loss Aversion’ theory by Amos Tversky and Daniel Kahneman which was formulated by two researchers in 1979. The deduced that people would prefer to ‘not lose Rs. 500’ than to ‘gain Rs. 500’. The bottom line of this theory is that losses loom larger than profits

This theory forms an interesting part of behavioral finance which suggests that people are more prone to sadness than happiness and that even if there has been a profit of Rs. 200 and a loss of Rs. 150, the person is likely to feel sad about the loss, instead of celebrating the profit.

The ‘Loss Aversion theory’ by the researchers also suggest that for people to feel happy despite facing a loss, the value of the profit should at least by twice ore more as compared to the loss.  For example, is a person loses Rs. 200 in a trade, the profit should be at least Rs. 400 or more in a parallel trade, for the person to feel happy about the same.

This theory teaches us not just to treat profits and losses equally, but also to keep a check on our feelings when we focus on what we do not have in life instead of focusing on what we have in lives.

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