Diversification: An Investor’s Best Bet Against Loss Aversion

What really motivates investors? If you answered “gains,” you’re only partially correct.

As it turns out, people tend to hate losses more than they like gains. This basic principle of human psychology is called “loss aversion” and was first coined back in 1979 by Nobel Prize-winning economist Daniel Kahneman and his associate Amos Tversky.

What is loss aversion?

In his 2013 book, “Thinking, Fast and Slow,” Kahneman covered many different psychological systems and economic strategies. Loss aversion, however, was a primary focus throughout them all, because, as Kahneman put it: “The response to losses is stronger than the response to corresponding gains.” Bottom line, many times it is loss aversion that drives our decision-making.

This loss aversion bias in human thinking and behaviour is especially noticeable when it comes to the financial markets. When people’s money is at stake, as it is when investing, avoiding loss can be a powerful motivator in making investment decisions. In fact, one of the most useful tools at the investor’s disposal is rooted in loss aversion: diversification.

What is diversification?

While there are numerous strategies for risk management when investing, diversification is probably the best known and most frequently utilised — a testament to how effective many investors understand it to be.

In simple terms, diversification is the process of spreading out your investment capital over various assets, so that you are not overly exposed to any single asset. The concept is fundamentally based on the age-old wisdom of “Don’t put all of your eggs in one basket.” By holding a variety of assets in your portfolio, whether a range of stocks from different sectors and countries, and/or assets across different asset classes, the overall risk can be significantly reduced.

Diversification works because different assets can have different reactions to the same market events. One stock may react very negatively, while another will react less so — or even positively. If your portfolio is sufficiently diversified with a variety of assets, the logic goes, major losses are far more likely to be averted.

Diversification deep dive

That’s the basic definition of diversification. Let’s take a closer look at how we might further evaluate the assets in which we invest, and what might happen when investors fail to consider diversification.

While a company’s financials are certainly important to consider, market sentiment and its corresponding momentum can sometimes have just as much, if not a greater impact on a stock’s movements. There are many instances where shares saw spikes that were unrelated to fundamentals and later crashed solely based on market sentiment. For example:

• Asensus Surgical Inc. (ASXC) is a medical device company developing technology to make surgery less invasive, which has the potential to revolutionise the healthcare industry. As we can see below, Asensus’ stock has been subject to extreme movements, even without being considered a particularly volatile company.

• Investors had high hopes for BioNano Genomics Inc. (BNGO) at the start of 2021. The biotech company had raised $335 million, achieved significant progress with its Saphyr genomic sequencing system, and saw its stock soar. Prices then plummeted, seemingly without a clear catalyst for the loss.

• Tilray Inc. (TLRY) has plans to merge with fellow Canadian cannabis grower Aphria by the end of this year, together creating the largest cannabis company in the world. Yet, after a quick spike in February, Tilray shares crashed, losing much of their value.

Indices: a study in diversification

When we take a closer look at major market indices from around the world, the dramatic difference in returns between the individual stocks that comprise them becomes obvious. Each index as a whole includes a wide variety of companies, with highs and lows across the spectrum, naturally creating a type of built-in portfolio diversification for those who invest in them.

For example, here are the top and bottom performing stocks in 2020 from several leading global indices:

Investing responsibly with diversification

The financial markets will always carry some risk; indeed, as anything in life, when we stand to gain, we also stand to lose. Wise investors understand the need to be cautious and responsible, and incorporate proven risk management methods such as diversification into their investment strategies.

This is a marketing communication and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without taking any particular recipient’s investment objectives or financial situation into account, and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or a packaged investment product are not, and should not be taken as, a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this publication, which has been prepared utilising publicly available information.