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If you are a trader, chances are the recent stock market decline has prompted you to trade even more to recover your losses. Risking more capital when you have just lost some does not appear rational. But it is not just with equity traders. Some of us start risky business ventures just after we lose our jobs! The question is: Why do many of us take risky bets when faced with losses?
To answer this question, consider an experiment. Suppose, you are given Rs 5,000. You can keep the money or use the money to participate in a game of chance. If you win the game, you will receive Rs 9,000.
If you lose the game, you lose Rs 5,000. Would you play the game? You may well pass off the bet and keep Rs 5,000.
But consider another scenario. You are given Rs 9,000. If you do not play the game, the experimenter will take away Rs 4,000 from you. You can get back Rs 4,000 by playing and winning the game. Should you lose the game, however, you will have to give up Rs 5,000 as well. What would you do? Chances are you will play the game!
Interestingly, you can walk away with Rs 5,000 in both scenarios if you do not play the game.
But in the second scenario, Rs 4,000 was taken away from you. And parting with cash, or any possession for that matter, hurts. You will, perhaps, bet in an attempt to win back the lost money (Rs 4,000).
Prospect Theory
This behaviour, where we take decisions based on potential gains and losses rather than on the final outcome, is called Prospect Theory. And that is not all. You and I are typically averse to taking losses. The fact is that we are willing to take more risks to avoid those losses.
An example of this behaviour can be seen in the stock market. If a stock that you bought at Rs 100 declines to Rs 70, what would you do?
If you hold the stock, you suffer from loss aversion. You do not want to sell the stock and take a loss of Rs 30 per share. But in the process, you assume more risk on your investment capital, as the stock could decline further.
Traders often go a step further; they trade more aggressively to avoid losses and, in the process, risk more capital.
Now, you may not trade in stocks. So, think of the times in the past when you took high risk.
It is, perhaps, not a coincidence that you assumed such risk just after suffering losses.
(The author is the founder of Navera Consulting. Feedback may be sent to knowledge@thehindu.co.in)
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