What is Loss Aversion?
Loss aversion suggests that for individuals the pain of losing is psychologically twice as powerful as the pleasure of gaining.
Why is the pain of losing felt twice as powerfully compared to equivalent gains?
Loss aversion
, explained.
Bias
Description
In other words, losing something (an amount of money, an item, etc.) feels worse than gaining the same thing. It is a simple, but powerful bias that is is encapsulated in the expression “losses loom larger than gains” (Kahneman & Tversky, 1979).
Demonstrated by Amos Tversky and Daniel Kahneman in 1992, the key idea behind the loss-aversion bias is that people react differently to positive and negative changes of their status-quo. More specifically, losses are twice as powerful compared to equivalent gains. This idea is one of the foundations of prospect theory. Prospect theory describes how people choose between different prospective options and how they estimate the perceived likelihood of these different options. For instance, even though the likelihood of a costly event may be miniscule, we would rather agree to a smaller, sure loss — such as in the form of making a monthly or annual insurance payment — than risk a large expense (Outreville, 1998).
Companies and organizations often use loss aversion to their advantage. The information these organizations provide to the public can play into people’s biases and persuade them to make a particular decision. Insurance company websites will often display a long list of unlikely, yet costly outcomes that we may encounter should we not buy insurance (Outreville, 1998). This list of potential unfortunate events primes us towards the preference of avoiding these large losses and makes us forget about the small, but regular payments we would need to make into the future to ensure insurance coverage. In turn, loss-aversion helps explain the situations in which individuals display risk-averse versus risk-seeking behavior.
Additionally, there are particularly relevant consequences of loss aversion for financial decision-making. As discussed, people weight potential costs and failures more heavily than potential benefits and rewards. Thus, when making investment decisions, people more often focus on the risks associated with an investment, rather than on the potential gains. This can also lead to hyperfocusing on an investment that has lost money, while ignoring others. Further, people may be unwilling to make financial decisions that represent loss, such as selling a stock or house that has fallen below the price at which it was purchased, even though the decision itself may be the best option.
Another implication of loss aversion for behavioral finance is that price increases hurt more than price decreases help. For example, economist Daniel Putler found that, from July 1981 to July 1983, a 10% increase in the price of eggs led to a 7.8% decrease in demand, whereas a 10% decrease in the price of eggs led only to a 3.3% increase in demand.
Finally, loss aversion implies that scaling back is painful. When people contemplate buying new things, such as purchasing a fancier car or bigger house, they often tell themselves that they can always downsize if they can no longer afford these luxuries in the future. However, people underestimate how emotionally difficult this decision actually is.
Loss aversion explains why people tend to overweight small probabilities to guard against losses.
3 things you should know
- People are more willing to take risks to avoid a loss, so loss aversion can explain differences in risk-seeking versus aversive behaviour (Schindler & Pfattheicher, 2016)
- People would rather accept a small but certain reward over a mere chance at a larger gain.
- Loss aversion can explain why penalty frames are sometimes more effective than reward frames in motivating people (Gächter et al., 2009)
Example
For example, what would you choose: to receive a guaranteed payment of $900 or take a 90% chance of winning $1000 (and a 10% chance of winning 0)? Most people would decide to avoid the risk and take the $900, although the expected outcome is the same in both cases. However, if I asked you to choose between losing $900 and take a 90% chance of losing $1000, it is more likely that would probably prefer the second option (with the 90% chance of losing $1000) and thus engage in the risk-seeking behavior in the hope to avoid the loss.
The loss aversion bias is evident in other real-world examples.
- Health The website Stickk allows people to publicly commit to a positive behavior change (e.g. give up junk food). The goal-setting platform created by behavioral economists at Yale University and draws on the principle of loss aversion. For example, if a user wants to lose weight, the decision to not go to the gym may be coupled with the fear of loss—a cash penalty in the case of non-compliance.
Relevant TDL Insights
At TDL we are harnessing our knowledge on the loss aversion bias by studying and implementing interventions for social good.
Research on loss aversion is reducing plastic bags in the environment
Homonoff (2017) tested the theory of loss-aversion by assessing whether charging a tax of $0.05 (penalty) had a bigger impact on plastic bag reduction than offering a bonus (reward) of the same amount . Her results show that plastic bag used declined by 42% after the tax was implemented but did not change in the bonus treatment – evidence consistent with a model of loss aversion.
Loss Aversion and Carbon Pricing
Research at TDL on consumer responses and attitudes towards carbon pricing policies studied the role of loss aversion in a framing experiment focused on carbon pricing policy. We found that.framing consumer tax reimbursements as an incentive (reward) rather than a dividend or rebate (loss recuperation) increased the positive feeling towards the policy and intentions to spend the amount on green renovations.
Interventions
The United Kingdom’s Financial Conduct Authority (FCA) implemented a behavioral intervention aimed at increasing the amount of options people consider before choosing a retirement plan. Information was provided alongside a pension annuity quote which contained messages taking advantage of loss aversion.
In another intervention, the FCA found that loss aversion framing combined with using pre-filled switching forms and aptly-timed digital reminders led to the greatest increase in customers switching savings accounts.
