In the financial world, loss psychology is the emotional response to investment losses. This term can also be used more generally to discuss the psychological implications of everything from grieving loved ones to losing weight. Loss in general is a complex psychological issue and people have many ways of addressing it. In the case of people involved in trading of stocks, securities, and other financial products, loss psychology can become a serious stumbling block to success.
When people experience losses, the natural response is sadness. The way that people cope with this sadness is determined both by personal psychology and by experience. Someone who is adept at managing loss will be able to bounce back and learn from losses so that the experience is not repeated. A newer investor who feels less secure, on the other hand, may make blunders that exacerbate the loss.
Loss psychology starts before a loss even begins. Many people are loss averse, taking steps to avoid being exposed to losses, and this can play a role in investment strategies. People may fail to take action when they should because they are afraid of the consequences of a loss, and this can make a loss worse. Conversely, people who are not more risk averse may make dangerous gambles and take large losses as a result.
When an investment starts to lose value, loss psychology plays a critical role in determining how people respond. Some people become frozen and unable to act. They may panic as the value of the investment declines but not be able to take the initiative to sell, transfer, or otherwise get out of the investment before the loss becomes worse. Other people can identify the problem and take decisive action to minimize their losses as early as possible.
Once a loss is incurred, investors can learn from it, or dwell on the loss and have difficulty moving forward. Investors who can analyze a situation after the fact to identify when problems started occurring and what could have been done differently are more likely to succeed in the long term because they can use their mistakes as learning experiences. Investors stuck in a grieving mode or trapped in thinking about what-if situations are less likely to become confident, assertive investors who can make the right choice in a crisis.
There are a number of books about loss psychology that are designed to get investors to rethink the way that they look at and think about investments. Such texts are intended to help people process and learn from loss so that they can break out of harmful investment cycles.
