Charlie Munger: The Complete Investor (Columbia Business School Publishing)

by Tren Griffin

The deprival super-reaction tendency is more commonly called loss aversion, and it can cause investors to irrationally avoid risk when they face potential for gain, but irrationally seek risk when there is a potential for loss. In other words, people tend to be too conservative in seeking gains and too aggressive in seeking to avoid losses. The most important point to remember about this tendency is that it causes investors to do things like sell stocks too early and hold on to them for too long. It is very common for investors to hold on to losing stocks in the hope that somehow the price will rise and they will somehow break even. As another example of this tendency at work, many investors were so traumatized by stock losses after the 2007 financial crisis that they completely missed the subsequent rally in the markets. One of prospect theory’s most important contributions to finance is loss aversion, the idea that, for most people, losses loom larger than corresponding gains. The empirical evidence suggests we feel losses about two to two-and-a-half times more than we feel gains. —MICHAEL MAUBOUSSIN, AVER AND AVERSION, 2005