And we’re back. If you’re just joining us, this is part three of a four-part series on loss chasing. If you missed part one or part two, don’t worry, you can catch up by clicking on the links.
In the first two parts, we discussed the following:
- What loss chasing is.
- Why do people loss chase? (Spoiler, that warm fuzzy feeling has something to do with it).
- An in-depth case study
Otherwise, here’s a brief summary for those who like it quick and snappy.
In part one, we learn that Loss chasing is when a person repeatedly buys more shares after a price drop in an attempt to reduce the emotional impact of losing money.
In part two, we analyzed a case study and saw how our investor, Bob, was actually destroying his portfolio by loss chasing rather than positively contributing to it.
In this third part of our series, we’ll look at the science behind loss chasing, including what drives us to chase, the neurobiological factors involved, and the emotional and financial impacts.
Loss Chasing, The Great Minds Behind the Science
One of the biggest breakthroughs of the last century in economic science came from mapping out how people respond to gains and losses differently. This is represented in what’s called prospect theory.
This contribution by Amos Tversky and Danny Kahneman, Nobel Prize winners for their work in Economic Sciences, was a big deal for all investors (Kahneman and Tversky 1979). It was the first time that a clear explanation was provided for why people react so differently to gains and losses.
Losses, such as price drops below what was paid for the asset, trigger people to have a large appetite for risk in pursuit of “getting back to even”. Taking extreme risks to regain losses is precisely what many investors do when they lose.
Gains, such as when prices rise above what was paid, reduce risk appetite and encourage risk aversion, which is why people sell winning assets too early and miss out on upside gains. This is discussed elegantly in Terry Odean’s paper analyzing traders’ behavior (Odean 1998).
It was this very paper that gave me the idea when I was a Ph.D. student to build technology–which I discussed in part two–that helps people make better decisions and is now offered here at Prof of Wall Street.
Another central driver of loss chasing is the sunk cost fallacy. This logical fallacy misleads us to believe that money invested (or lost, in this case) into something justifies investing more money or resources into it.
This is dangerous because we get tricked into believing that increasing the investment can somehow “right the wrong”, but in reality what’s happening is “throwing good money after bad”.
Later in this article, I’ll discuss an approach to avoid continually making this type of mistake in investing scenarios.
One of the most well-known biases is overconfidence in making investment decisions.
This is well known partly thanks to insightful research by behavioral finance professors Terry Odean and Brad Barber, who show in this and other key papers that overconfidence leads to major trading losses (Barber and Odean 2001a).
Relatedly, they show that biases plus access to online trading accounts lead to bigger losses relative to pre-internet trading (Barber and Odean 2001b).
At first, it might appear that technology per se leads to more impulsive, rule-of-thumb decisions as compared to offline, effortful decision-making. Profs. Barber and Odean conclude, however, that overconfidence–and its near cousins, self-attribution bias and illusions of knowledge and control–is driving the drastic underperformance relative to phone call-based investing (Barber 2008).
Loss chasing relates to the illusion of control because allocating more resources to a losing position “feels” like an assertive action.
The trader believes they have more influence in the situation than they actually do. But in the end, buying more does not in fact have any impact on the price for the average trader and further losses are just as likely to occur.
Hey Neuroscience, Why Does This Happen?
There is a fascinating field you might not have heard of called neuroeconomics. This unique cross-pollinating academic area helps us understand why and how our brains and bodies function when we make economic decisions.
If you hadn’t already guessed it, this was my main area early in my research career and I was fortunate to work with some of the brightest minds in economics, neuroscience, finance, psychology, marketing, and biological sciences. My first paper was on the effects of testosterone on stock trading in males and, yes, you should check it out (Nadler et al. 2017).
My research showed that increasing testosterone escalates men’s buying prices and this creates larger price “bubbles”. In regards to loss chasing, we see convergent evidence that the tendency to react to losses by taking on additional risk is part and parcel of being human.
What’s fascinating is that this functional process is detectable in our brains when we make decisions.
During a scan of a functional magnetic resonance imaging (fMRI) machine, you can actually see the part of the brain that produces dopamine (our “feel-good” hormone) activates differently for losses than gains (Fox and Poldrack 2009).
As we’ve all probably experienced, losing triggers negative emotions such as fear, anger, and frustration and our bodies respond in kind by releasing hormones, increasing heart rate, upping respiration, and increasing blood flow (Singh et al. 2022).
Heart rate variability, a measure of stress, also changes during volatile markets and most strongly for inexperienced traders (Fenton-O’Creevy, Mark, et al. 2012).
If you’re interested in the evolutionary origin of prospect theory preferences, you should check out this paper (it also explains it in the context of political outcomes) (McDermott, Fowler, and Smirnov 2008).
This is partly why people struggle the most to make good decisions during “hot” moments.
When our brains and bodies are in an aroused state, the objectives and decision-making pathways change relative to when we are in a “cool” state (Ariely and Loewenstein 2006).
Some researchers even propose that emotional arousal is a major limitation to rational decision-making itself (Kaufman 1999). Also, we have much less experience in hot states so we struggle to maintain composure and executive function out of our comfort zone (Schwartz 2000).
A repeated finding in the psychophysiology research is that keeping emotions in check improves performance while pushing down the emotions it does not (Hariharan et al. 2015). For example, acknowledging the anger in the loss and the excitement and fear of a gain can better position you to make the correct next decision instead of falling prey to behavioral biases that hurt your performance.
If you’ve been investing or trading for some time, it might resonate with you that experience reduces arousal, meaning that being through various challenges in the market prepares investors to cope with the next crisis(Lo and Repin 2002).
Loss chasing, an irrational decision-making reaction to losses, isn’t limited to investing. We also see larger risks taken after losses in other domains of life, such as the loss of a relationship in a breakup (Moreau et al. 2011), and even at the corporate level among troubled firms (Bowman 1982).
Not that all active investors fall under this category, but pathological gambling is largely driven by this dynamic and loss chasing is one of the criteria used to define addictive gambling (Guglielmo, Ioime, and Janiri 2016).
Studies integrating methods from behavioral economics and cognitive neuroscience may provide greater insight into the nature of these disorders and can be at least partly addressed by how user interfaces and decision-framing are created.
This, and other interdisciplinary research, helps us “see” into our decision-making processes and devise interventions or processes that help us make better decisions.
Side note: There are likely additional facets of loss chasing, such as Optimism Bias, denial, and many other candidates. The challenge with interpreting raw trading data is that there is too much ambiguity about what the decision-maker is feeling, experiencing, and thinking.
Even more vague, is their intent when they do act, or abstain from acting (“not acting” is a major missing variable, by the way) is completely absent from the record (candidly, this was a major motivator for developing SmartTrade).
The insights from this interdisciplinary field provided a richer understanding of how our ancient biological systems serve or fail us in our current, complex modern lives. They also led us to build technology that helps investors make better decisions (more on this later).
So, now that we’ve looked at the neurobiological factors, what are the negative effects of loss chasing? Let’s find out.
Emotional Impacts Of Loss Chasing
Sustaining losses is often stressful, can cause anxiety, and affect confidence and professional self-esteem. Whether investing on behalf of clients, your own family, and/or yourself, a loss can cause us to question ourselves and take a closer look at how we operate. And it should, as we do have much to learn from losses and mistakes.
However, the problem with trying to “undo” a loss, often done by reducing average cost basis, by buying more among loss chasers is that it accomplishes the opposite result: this creates more stress.
The loss-chasing investor experiences more stress because they have increased their bet on a losing asset and the subsequent movements of that asset are now much more consequential to their portfolio had they done nothing or sold the position.
As mentioned earlier, compulsive and addictive gambling is largely driven by loss chasing. This is because the very pursuit of most types of gambling is designed to create at least periodic losses.
It’s a known and exploitable risk-seeking mechanism that provides an endless supply of willing gaming participants who’ll take more risk to “get back to even”.
Much like smoking a cigarette to get rid of a nicotine craving, this behavior can be destructive for many. However, learning to cope with losses is a crucial skill that all active managers must have, so let’s see what the financial impacts are and how we can better handle them.
Financial Impacts: Is Buying Losing Stocks “Bad” Behavior?
What makes an investment behavior “good” or “bad” is strictly based on observation: if the strategy and/or behavior generates alpha then it is considered additive, and subtractive if not. And like most things in life, the answer here regarding buying “losing” stocks is “it depends”.
There is no necessary restriction on buying assets that are in losing positions. I’ve seen investors who buy large positions in stocks where they are in a losing position and generate significant and high returns through “dip buying”.
For consistent loss-chasing investors, there are potentially serious financial downsides. Not only is there more capital at play in an underwater investment but the entire portfolio could be thrown off-kilter by overweighting in speculative positions and experiencing higher volatility overall (again, stressful).
Even if someone successfully buys a dip, these gains could be “fumbled” by not selling them strategically. This occurs if the investor misses the opportunity to capitalize on the upside by not selling the gains, only to ride it all the way back down and earn a “Saddle Award” (I have an interesting case like this, I’ll write about it in a future article).
Avoiding destructive trading patterns requires first knowing whether you, the unique investor, display a particular bias. In this context, you need to know your track record of buying “losing” stocks.
To my knowledge, the only way for an investor to definitely know whether they create or destroy value by buying more or losing positions in your portfolio is to have their trade data analyzed.
And that, my friends, requires the technology we built at Prof of Wall Street through our Investor Optimization service.
You can try doing it manually if you’d like, but it’ll take a long, long, time and you’re likely to run into computational ambiguity leading to unreliable results (trust me, I built it with a team of very smart quants and computer scientists).
And this concludes part three of our four-part series. I hope you enjoyed learning about the psychological and biological factors that play a part in our decision-making. And ultimately, the emotional impacts that come with loss chasing.
In part four, we’ll look at strategies you can use to avoid loss chasing, including alternatives and how they can apply to you whether you’re an investor, manager, or advisor. I can’t wait to share all my inside secrets with you.
Citations
Barber, Brad M. 2008. Online Investors: Do the Slow Die First?
Nadler, Amos, Peiran Jiao, Veronika Alexander, Cameron Johnson, and Paul Zak. 2017. “The Bull of Wall Street: Experimental Analysis of Testosterone and Asset Trading.” Management Science, September. https://doi.org/10.1287/mnsc.2017.2836.
Odean, T. 1998. “Are Investors Reluctant to Realize Their Losses?” The Journal of Finance. https://onlinelibrary.wiley.com/doi/abs/10.1111/0022-1082.00072.