What You Will Learn From This Article
- What loss aversion is, and the research behind why losses and gains aren’t felt equally
- Buffett’s two-rule list, never lose money, never forget the first rule, and the arithmetic that makes it serious rather than a joke
- Why holding losing investments too long and selling winners too early are both symptoms of the same bias
- A practical way to make decisions that accounts for this asymmetry instead of being run by it
If losing R10,000 and gaining R10,000 felt like equal and opposite experiences, a huge amount of bad investing behaviour would simply disappear. They don’t feel equal, and understanding exactly why is one of the more useful things an investor can learn about their own mind.
The Research Behind Loss Aversion
The scientific grounding for this comes from psychologists Daniel Kahneman and Amos Tversky, whose 1979 paper “Prospect Theory,” published in the journal Econometrica, provided the first rigorous evidence that people evaluate losses and gains asymmetrically. Kahneman later won the 2002 Nobel Memorial Prize in Economic Sciences for this work. The general finding, refined across decades of subsequent research, is that a loss of a given size is felt roughly twice as intensely as a gain of the same size feels good.
Munger arrived at a similar observation through decades of watching investor behaviour rather than laboratory experiments, cataloguing it among the tendencies in his 1995 Harvard speech, “The Psychology of Human Misjudgment.” His version was blunter: people react to a loss, or even a threatened loss, far more intensely than they react to an equivalent gain, and that overreaction quietly drives some of the worst decisions investors make.
Where This Shows Up in Real Portfolios
The clearest symptom is an investor holding a losing position for months or years, well past the point their own analysis would justify, simply because selling would mean converting a paper loss into a real, final one. As long as the position is unsold, there’s a story available: it might come back. Selling ends that story and forces an admission that the money is genuinely gone. Loss aversion makes that admission feel disproportionately painful, so it gets delayed, often at real financial cost as the position continues to underperform.
The mirror image is just as common: selling a winning position too early to “lock in” the gain, out of fear that giving any of it back would feel worse than the pleasure of having earned it in the first place. Both behaviours point the same direction, holding losers too long and winners too briefly, and both are driven by the same underlying asymmetry rather than by careful analysis of what each specific investment is actually worth going forward.
Buffett’s Rule, and the Arithmetic Behind It
Buffett’s famously blunt summary of this whole area is a two-rule list: Rule No. 1 is never lose money, Rule No. 2 is never forget Rule No. 1. It reads like a joke on first hearing it, since obviously no investor sets out to lose money. The rule isn’t really advice to avoid all risk. It’s a reminder about arithmetic that many investors underestimate:
- A 10% loss requires an 11% gain just to get back to even
- A 20% loss requires a 25% gain
- A 30% loss requires a 43% gain
- A 50% loss requires a 100% gain
- A 60% loss requires a 150% gain
- A 90% loss requires a 900% gain
The relationship isn’t linear, it gets dramatically worse the larger the loss becomes. This is the actual substance behind Buffett’s rule: avoiding a large loss in the first place matters more to long-term outcomes than capturing any single large gain, because the recovery math for losses is so much more demanding than most people’s intuition suggests.
Making Decisions That Account for the Asymmetry
Since loss aversion operates automatically, the practical goal isn’t to switch it off, that isn’t realistic, but to build decisions that don’t depend on overriding it in the heat of the moment.
- Decide your position-sizing and exit approach for an investment before you buy it, while you can think clearly, rather than while a loss is already unfolding and loss aversion is already active
- When considering whether to sell a losing position, ask whether you’d buy it today at the current price, knowing what you now know, rather than asking how far it’s already fallen from what you paid
- Remember the recovery arithmetic above specifically when a position is down 30% or more; the temptation to “wait for it to come back” often underestimates just how much of a rebound is actually required
- Recognise that selling a winner purely to avoid future regret, rather than because your analysis of its value has changed, is loss aversion operating in reverse
Key Takeaways
- Loss aversion, documented in Kahneman and Tversky’s 1979 prospect theory research and independently observed by Munger, means losses are typically felt roughly twice as intensely as equivalent gains
- This asymmetry explains two common, opposite mistakes: holding losing positions too long, and selling winning positions too early
- Buffett’s “never lose money” rule is a practical response to unforgiving recovery arithmetic, a 50% loss requires a 100% gain just to break even
- Deciding your approach to a position before you own it, rather than while a loss is actively unfolding, is the most practical defence against this bias
Frequently Asked Questions
Does loss aversion mean I should never sell an investment at a loss?
No. It means the decision to hold or sell should be based on a fresh assessment of the investment’s value today, not on an emotional reluctance to convert a paper loss into a realised one. Sometimes selling at a loss is the correct decision; loss aversion is what makes that correct decision feel disproportionately difficult.
Why does a 50% loss need a 100% gain to recover, not just 50%?
Because the gain needed is calculated on the smaller, already-reduced amount. If R100 falls 50% to R50, that R50 then needs to double, a 100% gain, just to get back to the original R100. The percentage required to recover always exceeds the percentage that was lost, and the gap widens as the loss gets larger.
Is it possible to overcome loss aversion through willpower alone?
Not reliably. It’s a well-documented, automatic psychological response, not a knowledge gap. The more realistic approach is designing decisions and rules in advance, before emotion is engaged, rather than trying to reason your way past the bias in the moment it’s happening.
How is selling winners too early related to loss aversion, if it’s about a gain?
It’s loss aversion applied to a hypothetical future loss, the fear of watching an existing gain shrink or disappear feels like a loss in itself, even though technically nothing has been lost yet. That fear can push investors to sell prematurely, based on emotion rather than a genuine reassessment of the investment’s prospects.
Does this bias affect professional investors too, or only individuals?
Both. Kahneman and Tversky’s research and Munger’s own observations describe a general human tendency, not one limited to inexperienced investors. Professional fund managers build formal rules and processes specifically because they know they’re subject to the same bias as everyone else.
This article was researched and drafted with the assistance of AI tools and reviewed for accuracy. It is general information, not personalised financial advice. Historical and biographical details were verified against publicly available sources at the time of writing, but please confirm any date or fact that matters to you independently before relying on it.
