Lesson 5 of 7 · 13 min
Emotional biases I: loss aversion and overconfidence
Loss aversion makes losses hurt far more than equal gains please, so investors hold losers and sell winners; overconfidence makes them trust their own judgement too much, so they underestimate risk, overestimate returns and diversify too little.
In short
- Loss aversion: a strong preference for avoiding losses over achieving gains. Gains and losses are judged against a reference point using an S-shaped, asymmetric value function: risk-averse for gains, risk-seeking for losses.
- The disposition effect: holding losers too long (hoping to break even) and selling winners too soon (fearing the gain will vanish). The portfolio can end up riskier than intended.
- Fix loss aversion with a disciplined approach: analyse investments and realistically weigh the probabilities of future gains and losses.
- Overconfidence: unwarranted faith in one's own abilities, often intensified by self-attribution bias (credit for successes, blame others for failures). Classified as emotional, though it has cognitive aspects.
- Two forms: prediction overconfidence (confidence intervals too narrow) and certainty overconfidence (probabilities too high).
- Fix overconfidence by reviewing all trades, winners and losers, over at least two years, and separating skill from luck.
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