Loss Aversion Vs. Opportunity Cost: Why We Cling To Poor Investments

When it comes to investing, our emotions may play a bigger role than we realise. Many investors find it difficult to sell an investment that has gone down in value, even when recovery seems unlikely. Two ideas can explain this behaviour: loss aversion and opportunity cost. Understanding these concepts may help us make more informed financial choices.

Table of contents

• What is the meaning of loss aversion and opportunity cost?
• How loss aversion leads to poor investment decisions
• What’s the connection between loss aversion and sunk cost fallacy?
• Examples of real-world investing
• Practical frameworks to evaluate whether to hold or sell

What is the meaning of loss aversion and opportunity cost?

• Loss aversion is a behavioural bias according to which the loss of fear tends to outweigh the satisfaction of equivalent gains. For example, losing Rs.10,000 hurts far more than the joy of gaining Rs.10,000.
• Opportunity cost refers to what we give up when we choose one option over another. In investing, it refers to the potential returns we might miss out on because our money is locked in a poor-performing asset instead of being used elsewhere. Opportunity cost investing is the process of comparing alternatives before deciding where our money should stay.

How loss aversion leads to poor investment decisions

Loss aversion often makes people cling to investments that no longer serve them. Instead of asking where their money may potentially earn returns at the given point in time, they focus on recovering their original investment. This can create some problems:

• It may delay cutting losses in investments, even when recovery seems unlikely.
• It may encourage holding on to shares, real estate, or fixed deposits that could underperform for years.
• It may divert attention from future potential and keep the investor focused on past mistakes.

Also Read: How Fear and Greed Impact Risk Management in Investing

What’s the connection between loss aversion and sunk cost fallacy?

Loss aversion is closely linked to the concept of sunk cost fallacy. A sunk cost refers to the money that has already been spent and cannot be recovered. For instance*, if you bought shares at Rs. 500 and today they are priced at Rs. 200, the Rs. 300 loss per share is already gone. But, because of sunk cost fallacy, many investors may continue to wait for the stock price to return to Rs. 500 – or even put in more money – before they decide to sell.

Past cost cannot dictate future choices. What matters is whether the money has higher potential for growth if it remains in that investment or if it moves to another one.

Example for illustrative purposes only.

Examples of real-world investing

• Shares of a fading company: An investor buys a company’s stock at a high price. Years later, profits fall, and the business faces strong competition. Even then, the investor refuses to sell, hoping to recover the purchase price. Meanwhile, the same money could have been invested in fundamentally stronger companies.
• Real estate projects: Some people invest in real estate that remains unsold or unused for years. Maintenance costs rise but the owner hesitates to sell at a lower price. Both time and money are lost due to attachment to the original cost.
• Fixed deposits or low-yield products: While they are stable, savings avenues like fixed deposits may not offer inflation-beating returns over time. Sticking to them only because they feel familiar ignores the opportunity of moving some funds to more profitable potential options.

Practical frameworks to evaluate whether to hold or sell

Emotions can easily get in the way of investment decisions, but these simple checks can offer clarity to the investor:

• Ask about opportunity cost: “If I had this money fresh in hand today, would I still choose this same investment?” If the answer is no, it may be time to reconsider.
• Review future prospects, not past prices: Focus on the earning potential, growth, and stability of the investment going forward. Past performance may or may not be sustained in future.
• Set exit rules in advance: Some investors may decide a maximum percentage of loss they are willing to tolerate. Once that upper limit is reached, they exit calmly rather than wait endlessly.
• Diversification is key: Having a mix of assets reduces the pressure of any single investment decision and makes cutting losses in investments less painful.
• Seek professional advice: Talking to a trusted advisor can reduce emotional bias.

Also Read: Value of Discipline: Behavioural Finance and Mutual Fund Investing

Conclusion

Investing may seem like a numbers game, but human psychology plays a very important role in the decisions we make. Loss aversion and sunk cost fallacy explain why investors may hold onto losing stocks or other assets long after they have stopped performing. That does not mean one should rush to sell at the first dip. But consistent underperformance relative to other stocks in that category may merit reconsideration. By asking simple questions and creating small rules, investors may be able to reduce their emotional biases. While not all biases can be avoided, learning how to free up money for potential opportunities is a key investment skill.

At Bajaj Finserv AMC, we recognise that emotions are the cornerstone of investor behaviour – not just for investors but for investment professionals too. That’s why, behavioural finance is at the heart of our investment philosophy, InQuBe , which combines the Information Edge, Quantitative Edge and Behavioural Edge. By understanding, tracking and monitoring market sentiments and our own investment biases, we seek to make mindful and strategic investment decisions. Get the Behavioural edge by investing with Bajaj Finserv AMC. Read more about InQuBe here.

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