The Hindu Business Line : What is loss aversion?

Consider this. My friend bought 500 shares of MTNL at Rs 155 in February. He wanted to sell his holding and take profits before trading closed on March 10.

But he was told that the stock was likely to go up further. So, he sold 500 shares at Rs 159 and then bought 300 shares at Rs 162, all on the same day! Is his behaviour rational?

My friend wanted to take profit even though MTNL had not moved much. Yet, he did not sell when the stock declined to Rs 139 soon after he bought it.

He was suffering from what behavioural psychologists call "loss aversion".

That is, we typically ride our losses longer with the hope of making profits at a later date. We, however, take our profits sooner, not wanting to risk losing the unrealised gains.

Loss aversion, perhaps, explains why my friend sold the shares.

But why did he buy 300 shares thereafter? The buy/sell strategy actually amounts to selling only 200 shares, which he could have done anyway.

Behavioural psychologists have shown that we engage in "mental accounting".

That is, we mentally place transactions in different accounts, and the money in one account is not transferred to another.

My friend had opened two such mental accounts. One was for the 500 MTNL shares. A round-trip led to a profit of Rs 4 per share, not taking into account brokerage.

He had already decided to buy a book on technical analysis with the realised profits!

The second account contained 300 MTNL shares bought at Rs 162 per share.

This was an independent transaction on which my friend was willing to suffer loss aversion.

(The author is Head, Research, Navia Markets)

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