Loss Aversion

" Prospect Theory: An Analysis of Decision under Risk "

This theory will explain how people feel about loss called "loss aversion"

1)Imagine that you have been given $1000 and have been asked to choose between A) guaranteed to win additional $500 B) a chance to flip a coin if it heads , you receive another $1000; tails you get nothing more..

2) Now Imagine that you have been given a $2000 and asked to choose between A) guaranteed to lose $500 B) a chance to flip a coin if it heads you lose nothing ; tails you lose $1000 .

Even though in both cases the outcome is exactly same for both options ( option A you will leave with $1500 and option B you will get either $1000 or $2000 depending on the coin) the research suggests more likely you will choose option A in 1st case while option B in 2nd case.

This explains why many investors sell their profit making shares more quickly compared to loss making shares. According to one research which studied thousands of patterns the stocks that investors sold outperformed the stocks they hold by 3.4% .

So in stock market it is better to sell the stocks which are making losses ( over a long period ) compared to selling the shares which are in profits . It will not only improve you returns in long term , but also offset that losses to other gains which reduces TAX burden .

"Why Smart People Make Big Money Mistakes" - Gary Belskey & Thomas Gilovich