What does 'loss aversion' refer to in emotional biases?

Loss aversion refers to the psychological phenomenon where individuals experience a greater emotional response to losses compared to equivalent gains. This means that the pain of losing a certain amount of money is felt more intensely than the pleasure associated with gaining the same amount. This principle, rooted in behavioral finance, suggests that people are more motivated to avoid losses than to pursue gains, influencing their decision-making processes.

In practical terms, an investor might hold onto losing investments longer than they should, hoping to avoid realizing a loss, while being more likely to sell winning investments too quickly to lock in gains. This behavior can lead to suboptimal financial decisions, highlighting the significant impact that emotional biases have on investor behavior.

The other options do not accurately capture the essence of loss aversion. For instance, overvaluing potential gains and favoring potential losses do not encompass the core idea of loss aversion. Loss aversion is fundamentally about the disproportionate emotional reaction to losses rather than simply favoring one over the other. Similarly, the overestimation of losing investments pertains more to risk perception rather than the emotional response tied directly to loss versus gain.