Many of the time, we have to make decisions from options, there is a risk of loss and an opportunity for gain, and we must decide whether to accept the gamble or reject it.
It has been proven that, emotionally, a loss ‘weighs’ about twice that of a similar gain. Social scientists call this loss aversion. “Losses loom larger than gains” and that people are loss averse.
Business – When we show fear of loss to people and sell our products then it will become easy to sell our products to them. The firm has its own entitlement, which is to retain its current profit. If it faces a threat of loss, it is allowed to transfer the loss to others.
Investment – When there is an increase in a stake, our loss aversion also increases with it. When we have invested in stocks and the price of it falls and we know that we have incurred loss but we do not book it. So, we sit on the stock, even if the chance of recovery is small and the probability of further decline is large. If we book loss then it becomes real and that is more painful. Fear of loss stops us from booking loss though it has already been incurred.
We should make a basic calculation of what would be future cash flow generation from the company and what if our assumption get fails. These basic calculations help to understand the risk and return scenario so that we can make a rational decision. And also, can use the margin of safety concept properly. We should be ready with a calculation that mentioned what can be a probability of losing some % of our current net worth if an investment does not work according to our plan so that we get mentally prepared in advance and also make a decision accordingly.
This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.