Do you suffer from loss aversion?

GAME TWO You are given Rs 8 lakh. This is yours to take home. Now you need to choose: you can return Rs 2 lakh from this money imagine holding the cash and having to count out Rs 2 lakh to give back or flip a coin. If the coin is heads you must give back Rs 4 lakh. If it is tails, you the entire Rs 8 lakh home or to the nearest car showroom/mall/jewellery store. In the first case you get a sure win of Rs 6 lakh. In the second case, where you flip a coin, you get either Rs 4 lakh or Rs 8 lakh.

8226; What did you choose? The sure win in both cases or sure win in one and flipped the coin in the second? Statistics show that 87 percent of people choose the sure win in the first instance and took home Rs 6 lakh, but take the gamble in the second.

8226; Why do we do this?

Because we hate to 8216;lose8217;. In the first case there is no loss from the money we are holding, so most people opt not to toss the coin. In the second game, there is a loss from the money held, so most people decide to toss the coin to retain what they hold, and maybe win some more. These games prove that most people are not 8216;risk averse8217; but 8216;loss averse8217;. We hate to lose money. In fact, we weigh losses roughly twice as heavily as gains. Called 8216;myopic loss aversion8217; in behavioural economics, this phenomenon explains a lot of 8216;why8217;s in the way we invest.

Let8217;s play again: choose one of the following options:

Option one: Your portfolio will appreciate 10 per cent and the cost of living will rise 15 per cent.

Option two: Your portfolio remains flat and the cost of living rises 5 per cent.

8226; What did you choose? Option One? If you did, so did most other people in the world who were polled on this question. People strongly favour the first over the second, even though the net effect of both is the same: a loss of purchasing power of 5 per cent. Reason: same as before, we hate to lose and a portfolio remaining flat is a loss over money that grows.

8226; Why do these games affect us as investors?

8216;Risk profiling8217; has gained ground amongst the Indian investors in the last one year. Websites, articles in the media and mutual fund and insurance companies exhort us to make investment decisions based on our risk profile. We answer a set of questions and our total score will tell us whether we are conservative, moderate or aggressive in our investment behaviour. While these tests give a handle to us to judge how much risk we can take, we do need to remember that our investment decisions are based not only on the risk profile that gets thrown out of a quiz, but also on the circumstances facing us 8211; will I be equally risk-averse with my only lakh as I would be with my 100th lakh? We may make better investment decisions if, along with the risk profiling, we factor in the final goal and the current financial position we are in, before taking an investment call. Also, being aware of the myopic loss aversion hating to lose that plagues most investors, we may be less reluctant to sell a loser and reallocate the money into a more profitable instrument, than we are today.

Play again: You get free tickets for a famous show. You are on the road to the show, halfway through you get stuck in a traffic jam. You see a turn ahead that will take you back home. The jam looks as if it will take a long time to clear. Will you go back?

You bought Rs 10,000-a-seat tickets for the same show. Same jam. Same decision? Or will it be different this time?

Think about it, your retirement funding could depend on the answer you give.