Question

pick one bias or look up one and provide

1. A general description of the bias

2. An example of how that bias could be applied in a personal finance context.

Answer 1

What Is Bias?

A bias is an illogical preference or prejudice. It's a uniquely human foible, and since investors are human, they can be affected by it as well. Psychologists have identified more than a dozen kinds of biases, and any or all of them can cloud the judgment of an investor.

LOSS AVERSION

Loss aversion is a tendency in behavioral finance where investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains. The more one experiences losses, the more likely they are to become prone to loss aversion.

Research on loss aversion shows that investors feel the pain of a loss more than twice as strongly as they feel the enjoyment of making a profit.

Selling Winners and Holding Losers

Many investors don’t acknowledge a loss as being such until it is realized. Therefore, to avoid experiencing the pain of a “real” loss, they will continue to hold onto an investment even as their losses from it increase. This is because they can avoid psychologically or emotionally facing the fact of their loss as long as they haven’t yet closed out the trade. In their subconscious, if not their conscious, thinking, the loss doesn’t “count” until the investment is closed. The negative effect of this, of course, is that investors often continue to hold onto losing investments much longer than they should and end up suffering much bigger losses than necessary. That’s what loss aversion looks like in practice.

Well, how do you guard against the loss aversion bias? One practical step is to always use firm stop-loss orders to minimize your potential loss in any trade. That kind of pre-commitment to always limiting your risk helps to mitigate the tendency to fall into a loss aversion trap.

Examples of Loss Aversion

Below is a list of loss aversion examples that investors often fall into:

• Investing in low-return, guaranteed investments over more promising investments that carry higher risk
• Not selling a stock that you hold when your current rational analysis of the stock clearly indicates that it should be abandoned as an investment
• Selling a stock that has gone up slightly in price just to realize a gain of any amount, when your analysis indicates that the stock should be held longer for a much larger profit
• Telling oneself that an investment is not a loss until it’s realized (i.e., when the investment is sold)