Loss aversion bias is an emotional bias which negatively impacts investors portfolios over a period of time. Daniel Kahneman and his team came across this bias during their research about prospect theory in behavioural economics theory. The pleasure of profit is not equal to the pain of loss. To be more precise, investors feel two times more pain with the losses than the pleasure with gains.
Due to this, they usually try to avoid losses thus avoiding emotional pain. Another implication of this is they usually prefer safer investments although returns on such instruments is low over a longer period of time. Another interesting outcome of this emotional behaviour is, investors usually try to exit profit making positions prematurely due to the fear of possibility of such investments turning negative thus losing an opportunity to compound such gains.
Similarly to avoid emotional pain due to loss, they stick to loss making investments. This behaviour over a period of time causes investors portfolios entirely filled with loss making and almost bad investments. Instead of taking investment buy / sell / hold decisions on the basis of reference point of their investment amount or by emotional decisions, investors can avoid loss aversion bias by objectively reviewing their portfolio periodically. One question they can ask is “Is this investment makes sense to keep in the portfolio or is it lying in the portfolio just because investment is already made in that”?
Most of the investors make this mistake of emotionally sticking to loss making companies and existing profit making companies due to this loss aversion bias which is also similar to disposition effect.
