Don't Sweat: How to Deal with Stock Market Losses

For amateur players of the stock market, a loss from one trade can bring that sickly feeling in the pit of the stomach, especially in the current economic climate.

To keep those feelings at bay, all that may be needed is a sense of perspective, such as the “portfolio approach” used by professional traders, a new study suggests.

If you invest in the stock market, you might be aware that it's a risky venture, but how you react to that risk — both practically and emotionally — can be affected by the view you take of your investments, the study shows.

The researchers had test subjects complete a series of 140 choices between a risky gamble and a guaranteed amount of return. The choices were completed in two sets: one that emphasized the choices in isolation, or individually, and one that emphasized them as one of many.

Choices in isolation are thought to be closer to how an amateur trader looks at the stock markets, whereas professional traders look at their entire set of trades, or portfolio.

The study results, detailed in the March 16 issue of the journal Proceedings of the National Academy of Sciences, showed that when making choices in isolation, people were more concerned about avoiding financial losses than with making gains, a phenomenon called "loss aversion."

But when the choice was made in the context of the full set of choices, the subjects were less worried about their potential losses.

To investigate what emotional factors might be involved in loss aversion, the researchers measured the subjects' skin conductance due to increased sweating as they learned the outcomes of their decisions.

The results for choices made in isolation produced much more sweat for losses than gains per dollar. But when the choices were made as part of a portfolio, this "over-arousal" effect disappeared and sweat levels were the same for gains and losses.

"These results highlight how a simple shift in perspective can influence both the emotional reaction to a financial decision, and the decision itself," said study co-author Elizabeth Phelps of New York University, whose lab was used to conduct the research.

The research, funded by a James S. McDonnell Foundation grant, the National Science Foundation, and Moore Foundation and Human Frontier Science grants, also shows that it's not just the knowledge of investments and the market that give professionals an edge, it's also the strategy of using a portfolio method to limit how much their emotional response influences their decisions.

"Though on average we may dislike losses more than we like gains, both in our behavior and in our physiological responses to them, it seems we have the power to change that," said study lead author Peter Sokol-Hessner, a graduate student at NYU.

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