Humans are hard-wired in ways that helped our ancestors survive over thousands of years. Investing in markets is a recent concept – the New York Stock Exchange (NYSE) was founded in 1817. Unfortunately, the cognitive processes that aided our ancestors may undermine our success in modern markets. Behavioral finance is an emerging field that examines how people use the tools of finance, rather than studying the tools themselves.
One common behavioral mistake is known as “myopic loss aversion.” Behavioralists have estimated that people hate losses roughly two-and-a-half times as much as they like gains. We exert more effort to avoid losses than to achieve gain. Suppose an investor’s portfolio rose 40% and then dropped 20%. He/she would feel the loss about 2.5 times as much as the gain. The drop causes heightened loss aversion, potentially leading the investor to panic and act against what he/she knows is rational.
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