Loss Aversion and the “Negativity Bias”

At HX Research, we spend a lot of time thinking about human psychology and how it can impact investing.

With the passing of Nobel prize-winning economist Daniel Kahneman last week, we decided to share one of our favorite notes inspired by him. Rest in peace.

Since launching in September 2019, I've shared many lessons I've learned during my over two decades on Wall Street.

This week, I'm sharing one of my favorite essays on a critical concept to consider when investing.

Whether you're a longtime reader or new to our writing, this is a good reminder of something hardwired in our brains that we must overcome...

One of the biggest arguments in all of investing is whether the markets are "efficient" or not.

The idea of an "efficient market" is that all the available information is "priced in" to stock prices. This means that investors have no natural way to gain an advantage.

But instinctively, we know this is not true. All you need to do is watch a stock drop 5% on an analyst downgrade or a tweet from the CEO, and the logic that this is all priced in doesn't stand up.

The primary reason why markets are not efficient is because, ultimately, human beings make the vast majority of investment decisions.

As much as we would like to say that these decision-makers are rational and unemotional, the reality is that hundreds of thousands of years of genetic programming still govern our actions. These responses were developed to keep the human race alive and worked! It's hard to override that with a couple of years of business school.

The most powerful of these responses, which impact trading, is called the "negativity bias." This is a condition in which adverse events impact our brains more than positive ones.

Research on human brain activity has shown that negative stimuli generate three to 12 times more physical (electrical) responses than positive stimuli.

One famous experiment done by economist and psychologist Daniel Kahneman had participants imagine losing or gaining $50. Even though the amount was the same, the emotional response of those losing the money was more significant. The negativity about losing something is much larger than the advantage of gaining something – even if it's the same amount at stake.

This makes sense... For ancient humans, a good meal from a fresh kill would trigger a positive response and a full stomach, but falling off a cliff would trigger death and no more responses.

Earlier in human history, paying attention to negative stimuli was a matter of life and death. But today, it gets in the way of good investing...

One of the most common issues is overemphasizing the "negative" factor and missing out on great opportunities.

My favorite example of this is not buying a world-class business because of the valuation or some recent short-term disappointment.

Our portfolio here at HX Trader is full of these kinds of opportunities. We look for great businesses with long histories of operational success and outstanding stock price performance that have stumbled because of something immaterial to the business's value.

Investors that have sold these stocks have overemphasized the negative. In many positions, we see companies that have beaten expectations on every metric but one, and the stocks tumble.

This is a prime example of negativity bias.

Has "negativity bias" ever COST you money in trading or investing? Tell us more in the comments section below…

Another problem is when we dwell on adverse events, even after they have passed.

I've fallen prey to this even in investing, where I would have a portfolio of 30 stocks but spend 90% of my focus on the one or two losers in that group.

Those stocks ended up being doubly dangerous because they were losing me money and prevented me from adequately focusing on the rest of the portfolio. This resulted in missed opportunities and – equally important – made me miserable.

Don't discount the psychological impact that "losers" can have on your investing beyond just the money you've lost.

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