Loss Aversion, Anchoring, and Sunk Costs

Why this matters

Ask an investor about a stock they own and they'll usually tell you two numbers: what it's worth now, and what they paid. The second number shouldn't matter to the decision in front of them. But for almost everyone, it does. This lesson explains why, and what it costs.

Loss aversion: losses loom larger

In their 1979 paper on prospect theory, Daniel Kahneman and Amos Tversky proposed that people value outcomes as gains and losses from a reference point, rather than as total wealth, and that the way they value them is generally steeper for losses than for gains.¹ In plain terms, losing $1,000 tends to feel worse than gaining $1,000 feels good. That's loss aversion.

For investors, the reference point is usually the purchase price. A stock bought at $50 and now at $45 feels like a loss to be avoided. The same stock bought at $40 and now at $45 feels like a gain to be protected. It's the same stock, at the same price, with the same future, but it feels completely different depending on your history with it.

Anchoring: the number in your head

Anchoring is relying too heavily on a number you've already seen when making an estimate. In a famous 1974 experiment, Tversky and Kahneman spun a wheel of fortune in front of people, then asked them to estimate the percentage of African countries in the United Nations. Those who saw the wheel land on 10 gave a median estimate of 25%; those who saw 65 gave a median estimate of 45%. A random number moved the answers, and paying people for accuracy didn't reduce the effect.²

Investors are surrounded by anchors: the price they paid, a stock's highest price of the past year, a round number like $100, or a price target someone posted. Each can quietly set what feels "cheap" or "expensive," regardless of what the business is worth.