The thought experiment that changed economics forever
In the late 1970s, Israeli psychologists Daniel Kahneman and Amos Tversky put their study subjects through a series of hypothetical bets. One of the most cited: would you accept a bet with a 50% chance of winning $150 and a 50% chance of losing $100? The expected value is clearly positive (+$25 on average), so a purely rational agent should always accept. The vast majority of people turn it down.
Kahneman and Tversky published their findings in 1979 in 'Prospect Theory: An Analysis of Decision under Risk,' one of the most cited papers in all of economics. Their conclusion: the pain of losing an amount of money is felt, on average, between 1.5 and 2.5 times as intensely as the pleasure of gaining that same amount. Kahneman would receive the Nobel Prize in Economics in 2002 for this work (Tversky had died in 1996, and the Nobel is not awarded posthumously).
The disposition effect: selling winners early, holding losers forever
The most-studied practical consequence of loss aversion in the markets is called the 'disposition effect': the tendency to sell investments that have risen in price (to 'lock in' a gain already psychologically accepted) and to hold onto ones that have fallen, waiting for them to 'get back to what I paid,' before accepting the loss as final.
Economist Terrance Odean analyzed more than 10,000 accounts at a US retail broker in 1998 and found that individual investors sold their winning positions 50% more often than their losing ones. The problem is that this is exactly the opposite of what any sensible investing playbook recommends: the stocks investors sold (the winners) went on to outperform, on average, the ones they kept (the losers) by more than 3% over the following year.
A real example: why so many people sold at the exact worst moment in 2008
imagine an investor whose portfolio falls 40% during the 2008 financial crisis. Rationally, if they still believe in their long-term investments, holding on (or even buying more at a discount) would be the sensible decision. But loss aversion pushes in the opposite direction in two simultaneous ways: first, watching the portfolio fall every day generates unbearable emotional pressure that pushes toward selling just to stop feeling that loss; and if they hold on instead, that same loss aversion later makes them resist selling even once the original reasons for investing no longer apply, simply because selling would officially 'realize' something they'd psychologically rather keep postponing.
Whoever sold near the March 2009 low turned a temporary loss (volatility) into a permanent one (realized risk) precisely for this psychological reason, not because of any rational calculation.
'Myopic loss aversion': why checking your portfolio often makes you a worse investor
Economists Shlomo Benartzi and Richard Thaler demonstrated an uncomfortable corollary of this bias in 1995: the more often you check the value of your portfolio, the more loss aversion you experience, because a volatile investment shows more 'red days' the more frequently you look, even though its long-term return doesn't change at all.
They coined this phenomenon 'myopic loss aversion' and calculated that checking a stock portfolio daily, instead of once a year, can make an investor perceive an asset as far riskier than it actually is over their real investment horizon, pushing them to take on less risk than would objectively suit them long-term.
- Checking the portfolio daily: maximum emotional exposure to short-term volatility.
- Checking the portfolio once a year: short-term volatility nearly disappears from view.
- The underlying asset doesn't change; what changes is how many times your brain processes its volatility.
How to defend yourself against your own loss aversion
You can't eliminate a bias that's built into how the human brain processes risk, but you can design your financial system to depend less on your willpower at the worst possible moment. Automating periodic contributions to your investments (instead of deciding manually every month) removes the emotional decision from the moment of buying. Checking your net worth on a reasonable cadence, not daily, reduces exposure to 'myopic loss aversion.'
And perhaps most useful of all: deciding in writing, before investing and with a clear head, under what objective conditions you'd sell a position, so you don't have to make that call in the heat of the moment, with the market falling and your amygdala in charge.
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Frequently Asked Questions
Psychologists Daniel Kahneman and Amos Tversky formally described it in their Prospect Theory (1979). Kahneman received the Nobel Prize in Economics in 2002 partly for this work.
Kahneman and Tversky's studies estimated that the pain of a loss is felt between 1.5 and 2.5 times as intensely as the pleasure of an equivalent gain, though the exact coefficient varies by study and context.
It's the tendency, empirically documented by economist Terrance Odean, to sell winning investments too soon and hold losing investments too long, exactly the opposite of what usually serves you best.
According to Benartzi and Thaler's research on 'myopic loss aversion,' yes: checking your portfolio too frequently increases perceived risk without changing real risk, which can lead you to make more conservative investment decisions than would suit you long-term.
By automating your periodic contributions, checking your net worth on a reasonable cadence instead of daily, and deciding in writing, with a clear head and before investing, under what objective conditions you'd sell, so you don't decide it at the worst emotional moment.