Introduction Loss aversion is behaviour which prevents investors from taking rational investments decisions. Number of behavioural economists have conducted research on this behaviour and published similar results. For all us a small Rs.10 loss can create more pain than pleasure created by Rs.1000 gain. Because of the pain created by the losses, investors tend to take irrational decisions. Time and again we have seen that not many investors are willing to sell their investments at a price lower than the acquisition price. They keep holding investments till they become worthless, because of the pain created by the loss. Not only investment decisions, but many decisions in our lives are driven by emotion. Imagine, what someone who bought tickets for First Day First Show movie at a very high price is likely to do, when he or she finds 10 minutes after start of the movie that it is boring? Taking risk can result in loss or gain. Avoiding risks also means foregoing gains and pleasures in life. If Yudhishthira had won the last throw of dice, he would have recovered all that he had lost and perhaps Mahabharata story might have taken a different path. All of us take risk. It is inherent to our nature. But none of us expect to fail. When we take risk, we expect Lady Luck to shower blessings on us. The act of risk taking has been there forever. While risk taking does not harm us, what is harmful is our irrational behavior towards risk. Irrational behaviour towards risk To understand our irrational behavior towards risk, let’s consider this example. This example was part of the research titled ‘Prospect Theory” conducted by Daniel Kahneman and Amos Tversky. Case 1 You have Rs.1000 with you and you are asked to take decision on one of the following options available: Option 1: A coin will be tossed, irrespective of the outcome, you will be paid another Rs.500 Option 2: A coin will be tossed, if head comes up you will be paid Rs.1000 and if tail comes up you will be paid nothing. Most people chose Option 1. Option 1 is safe option. Although we had opportunity to gain Rs.1000 in Option 2 most people preferred to take safer Option 1. Let's try to understand our behavior towards risk, by changing the case slightly. Case 2 You have Rs.1000 with you and you are asked to take decision on one of the following options available: Option 1: A coin will be tossed, irrespective of the outcome, the person will be asked to pay Rs.500. Option 2: A coin will be tossed; if heads come up, the person will pay Rs.1000, and if tails come up, the person will not have to pay anything. Most people choose Option 2. Option 2 is risky option. Although we had opportunity to lose Rs.1000 in Option 2 most people preferred to take riskier Option 2. This behavior is called Loss aversion. Daniel Kahneman and Amos Tversky found that people tend to avoid losses more than they seek gains. This leads us to take riskier decisions when faced with potential losses. Is that why Yudhishthira took the risky decision to bet Draupadi, in the hope recovering all that he lost? Loss aversion in real life Amar, Akbar and Anthony are agriculture students recently hired by a Chemicals and Fertilizers Company in Aurangabad. They decided to save Rs 5000 from their salary every month. However, they collected information on various investment options as follows: Amar collected the following information from his bank → 3 year recurring deposit with assured return of 7.2% → SIP in Equity Mutual Fund with no guarantee on returns. However, in the past returns have varied from -15% to +15% Akbar collected the following information from internet → 3 year recurring deposit with assured return of 8.5% from AA rated NBFC → SIP in Equity Mutual Fund with no guarantee on returns Anthony collected the following information from Investment Firm → SIP in Tax Savings Mutual Fund with Investment blocked for 3 years and returns in the range of -15% to +15% → SIP in Equity Mutual Fund for 3 years and returns in the range of -20% to +20%. What are the likely decisions by Amar, Akbar and Anthony? Based on the behavioural finance theories—loss aversion, heuristics, and biases—it is likely that Amar, Akbar and Anthony are likely to take the following decisions: Amar: Invest in 3 year recurring deposit with assured return of 7.2% Akbar: 3 year recurring deposit with assured return of 8.5% from AA rated NBFC Anthony: SIP in Tax Savings Mutual Fund with investment blocked for 3 years and returns in the range of -15% to +15%