Daniel Kahneman: Investors Need To Make Peace With Their Losses

In the book Choices, Values, and Frames, Daniel Kahneman and Amos Tversky explain why investors need to make peace with their losses. Here’s an excerpt from the book:

This analysis suggests that a person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.

The well known observation (McGlothlin, 1956) that the tendency to bet on long shots increases in the course of the betting day provides some support for the hypothesis that a failure to adapt to losses or to attain an expected gain induces risk seeking.

For another example, consider an individual who expects to purchase insurance, perhaps because he has owned it in the past or because his friends do. This individual may code the decision to pay a premium y to protect against a loss x as a choice between (–x + y, p; y, 1 – p) and (0) rather than as a choice between (–x, p) and (–y).

The preceding argument entails that insurance is likely to be more attractive in the former representation than in the latter.