Click Crash
Behavioural finance issues related to loss primarily revolve around how individuals perceive and react to losses, often diverging from rational decision-making models. Some key issues include:
1. Loss Aversion
- Definition: The tendency for people to prefer avoiding losses rather than acquiring equivalent gains.
- Impact: Individuals might hold onto losing investments longer than is rational in the hope of breaking even, leading to greater losses.
2. Prospect Theory
- Definition: Developed by Daniel Kahneman and Amos Tversky, it describes how people choose between probabilistic alternatives that involve risk.
- Impact: People evaluate potential losses and gains relative to a reference point, usually the status quo and losses have a more significant emotional impact than gains of the same size.
3. Disposition Effect
- Definition: The tendency to sell winning investments too early and hold onto losing investments too long.
- Impact: Investors may realise gains quickly to lock in profits but avoid realising losses to escape the pain of admitting a bad investment decision.
4. Endowment Effect
- Definition: The phenomenon where people assign more value to things merely because they own them.
- Impact: This can lead to an irrational attachment to losing investments, making it difficult to sell them.
5. Mental Accounting
- Definition: People categorise and treat money differently depending on its origin, intended use, or other subjective criteria.
- Impact: Losses might be accounted for differently depending on the mental account they belong to, leading to inconsistent financial behaviour.
6. Regret Aversion
- Definition: The tendency to avoid making decisions that could lead to regret.
- Impact: Investors might avoid selling losing investments to avoid the regret of making a decision that results in a realised loss.
7. Overconfidence
- Definition: A cognitive bias where individuals overestimate their knowledge, abilities, and the accuracy of their predictions.
- Impact: Overconfident investors may underestimate the likelihood of losses or overestimate their ability to recover from losses, leading to riskier behaviour.
8. Sunk Cost Fallacy
- Definition: The inclination to continue an endeavour once an investment in money, effort, or time has been made.
- Impact: Investors might throw good money after bad, continuing to invest in a losing position due to the amount already invested rather than cutting their losses.
9. Anchoring
- Definition: The tendency to rely too heavily on the first piece of information encountered (the "anchor") when making decisions.
- Impact: Initial purchase prices can anchor investors' perceptions of value, causing them to hold onto losing investments until they return to the anchored value.
