Motivation and emotion/Book/2018/Loss aversion

Loss aversion:
Why is the motivation to avoid loss stronger than the motivation to seek gain and what are the consequences?

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(3 min)

Overview

Imagine this: I offer to toss a coin, and if it lands on heads, I give you $100, but if it lands on tails, you owe me $100. Would you take this chance? Loss aversion implies that you wouldn't, that the amount you possibly will win would need to be at least double the amount you may lose before accepting the risk. This bias towards a particular behaviour and/or decision reflects loss aversion and the idea that the pain of losing is psychologically much larger than the psychological effect of gains of the same size.

Loss aversion is the tendency for people to prefer avoiding losses over acquiring gains of the same size. It is one of the most extensively researched human biases in the fields of decision making, cognitive psychology, behavioural economics, and marketing. Daniel Kahneman and Amos Tversky (1979) developed a widely recognised behavioural model known as prospect theory. Which used the concept of loss aversion to explain decision making in situations when outcomes are uncertain. Explaining how people make decisions under risk.

Loss aversion has been used to explain the endowment effect, sunk cost fallacy and the status quo bias; consequently, people often choose inaction over action (Kahneman, Knetsch, and Thaler, 1991; Samuelson and Zeckhauser, 1988)

Loss aversion affects everyday decision making in a number of ways. This chapter provides an overview of what motivates us to avoid loss rather than to seek gain, by discussing the varies theories related to loss aversion, and what the consequences of this are.

Focus questions:

What is loss aversion?
What are the consquences[spelling?] associated with loss aversion?
Why understanding loss aversion is important?
How can we avoid loss aversion and start making gains?

If you said no, that is an example of loss-aversion. As equal odds give a higher payout and rationally should be considered a favorable bet. (Kahneman, 2011)

Would you take this bet?

What is loss aversion?

"Losses loom larger than gains". Kahneman & Tversky (1979, p. 279)

Loss aversion is the tendency for people to prefer avoiding losses over acquiring gains of the same size (Kahneman and Tversky, 1979). Loss aversion has been used to explain the endowment effect, sunk cost fallacy and the status quo bias. As a consequence people often choose inaction over action (Kahneman, Knetsch, and Thaler, 1991; Samuelson and Zeckhauser, 1988). When a person is presented with two choices, one as gains and the other as possible losses, they are more likely to choose the choice framed as gains over losses even though the expected value results of both may be the same (Kahneman and Tversky, 1992). The pain of losing hurts more than gains, therefore we seek to avoid negative situations leading to risk aversion in gain scenarios and risk seeking in loss decisions.

Endowment effect

Loss aversion has been used to explain the endowment effect. The endowment effect is the tendency for people to overvalue goods that are perceived to own, rather than what is not in their "endowment". Thaler conducted the first experiments to show the endowment effect. Half the students in a university class were present with mugs and given the opportunity to exchange them with the students that did not receive a mug. He found that little exchange occurred because the students with the opportunity to exchange the mug overvalued it and set the selling price to high and those without the mug set their buying price too low . Extending on this, his results found that the amount students requested for compensation to part with the mug ("willingness to accept") once ownership of the mug had been established, was roughly twice the amount they would pay to obtain the mug ("willingness to pay") .

Thaler attributed the endowment effect to Kahneman and Tversky's (1979) prospect theory and assumes that loss aversion leads to an increased or over-valuation of goods in the selling standpoint as compared to the buying standpoint, “because removing a good from the endowment creates a loss while adding the same good (to an endowment without it) generates a gain" (Thaler, 1980; p. 44). Simply put, the pain of losing an endowed good is greater than the pleasure of gaining it. Sellers expect to suffer twice as much as buyers expect to benefit (Morewedge, Shu, Gilbert, and Wilson, 2009; & Kahneman, Knetsch, and Thaler, 1991).

According to the Loss Aversion Framework, the prospect of selling or losing a good (for example the mug) has a stronger influence on our decision making than purchasing or owning the good and this discrepancy manifests itself in the different prices between seller/buyer. Our assessment of the mug (or any endowment) varies to our relationship to it, we don’t care about the mug until it is ours. Loss aversion is thus, to some extent, a function of emotional attachment to the good that is given up and the simple fact we own an object makes it more valuable to us and harder to part with. The endowment effect has important implications, and is important for psychology, marketing, economics, etc. It creates market inefficiencies and irregularities in valuation such as differences between buyers and sellers, and a reluctance to trade which as a result of the loss aversion can delay or even prevent a trade from occurring (Morewedge and Giblin, 2015; Tovar, 2009).

The endowment effect results from loss aversion. Once we own something, we perceive it as more desirable than before owning it, and to loss it would hurt much more than if we were to simply gain it. Therefore, we tend hold onto things for too long rather than parting with them and making a potential gain.

Sunk cost fallacy

Imagine this scenario: You went to university for 5 years and got a law degree. You then want on the become a lawyer and have been in your career for 3 years. However, it is becoming clear that this is not a fulfilling career for you and is making you unhappy, nonetheless you decide to stay in it rather than looking for a fulfilling job because of all the time, effort and money you have invested. You feel like you have to stay in this unfulfilling job due to having made the initial investment of going to university etc and don’t want all those resources to go to waste.

Loss aversion has been used to explain sunk cost fallacy and its effects on everyday decision making. Sunk cost fallacy is an irrational behaviour that can explain a person’s tendency to continue with a course of action even after it has been demonstrated to be sub-optimal, as a result of previously invested resources (time, money, effort) . Sunk cost fallacy is commonly quoted as ‘throwing good money after bad’ because once on a course of action that one has invested resources, we continue this course of action and even invest more resources despite it being a losing proposition . Simply put, sunk cost is any cost that has already been invested and cannot be recovered. We won’t accept sunk cost due to loss aversion, and we want to avoid loss because we don’t like it and the pain of loss is greater than potentially acquiring gains (Kahneman and Tversky, 1981).

In the above example, the resources we have invested is what we call the sunk cost. They have been invested and cannot be recovered no matter what you do going forward. Now a decision has to made, given that you have already spent that money, time, effort etc, about what career is going to produce the best outcome for your future. The sunk cost fallacy then means planning not based on what outcome you think is going to be the best going forward but instead based on the desire not to see your past investment go to waste.

Sunk cost fallacy makes it difficult for us to quit something that we feel invested in, especially if we think we are losing something because of it. However most of the time it is better to accept your losses and move on because you will never recover the true value of something once it is gone. Understanding the sunk cost fallacy and our aversion to loss, is important to help you reassess your inability to change due to investments made and to make better choices that will lead to a happier and more fulfilling future.

Status quo bias

Imagine this scenario: You have been in a mobile phone plan for 1 year. After this time, you start seeing advertisements for another telecommunications company that has a more beneficial plan to your needs. You choose to remain loyal to your current phone provider and plan even though there is a better alternative. Why?

Status quo bias is a combination of loss aversion and the endowment effect. Status quo leads to inaction, a behavioural tendency to do nothing, sticking with a decision previously made, or to remain with the current state of affairs (or status quo), even if there is a better alternative. This behavioural tendency to persist at the status quo, is seen because the disadvantages of leaving the current situation loom larger than advantages (Kahneman, Knetsch, and Thaler, 1991). The status quo bias is taken as a reference point, and any change from the status quo is perceived as a loss. It is psychologically evaluated that the disadvantages of alternate options are seen as losses and are therefore weighted greater than their advantages (Kahneman et al. 1991; Samuelson and Zeckhauser 1988, Tversky and Kahneman 1991). As a result of status quo bias and our aversion to loss, the individual in above example prefers to stay with their current mobile phone provider to maintain the status quo, rather than to take a risk on an unfamiliar but potentially better service option.

Samuelson and Zeckhauser (1988) extensively studied status quo bias and performed a series of experiments that found that younger workers signed up to health insurance plans that were shown to have better premiums and deductibles, compared to older workers who stuck with their older but also less favourable plan. In relation to Kahneman and Tversky’s loss aversion statement that “losses loom larger than gains”, older employees may choose to remain in their older health insurance because they may be trying to minimise their losses rather than taking the risk on potential unfamiliar gain (Kahneman and Tversky, 1979). This explanation can also be extended to the endowment effect associated with loss aversion, that we choose to stick with the current state of affairs and to decisions we made earlier (preference for familiarity) because we own them and losing what we own hurts more than a possible gain.

The status quo bias can make people resistant to change and can have a significant effect on our decision making processes. Our aversion to loss, loss aversion, plays a significant role and favours our avoidance of risks, and limits opportunities and solutions.

Myopic loss aversion

Panicking can make investors make irrational investment decisions in sudden stock market changes

Myopic loss aversion is a temporary form of loss aversion that also causes perfectly rational people to make irrational decisions, especially investment decisions (Thaler, Tversky, Kahneman, and Schwartz, 1997; Haigh and List, 2005). Myopic loss aversion happens when we temporary lose sight of the bigger picture due to a certain event, panic and focus on the short term and what is happening immediately right now. This usually causes investors to panic sell financial stocks during a sharp decline in the market (Haigh and List, 2005; Benartzi and Thaler, 1995). Thaler, Tversky, Kahneman, and Schwartz (1997) found that even experienced financial investors panic during a sudden stock crash and attempt to sell all their stock because they didn't want to lose everything. A recent study examined this phenomenon and found that those who panicked and sold their stock during the 2007-2008 global financial crisis, ultimately lost more in the long term (Yao and Lei, 2015; Guillemette, Yao, and James, 2015). Bucher-Koenen and Ziegelmeyer (2011) showed that panic moving/selling cash resulted in loss aversion and was harmful to investors’ financial wealth.

Prospect theory

Asian Disease Experiment (Kahneman & Tversky, 1981)

Imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimate of the consequences of the programs are as follows:

Problem 1 [N = 152]:

A = 200 people will be saved [72% of respondents selected this option]
B = 1/3 probability that 600 people will be saved, and 2/3 probability that no people will be saved [28%]

Problem 2 [N = 155]:

C = 400 people will die[22%]
D = 1/3 probability that nobody will die, and 2/3 probability that 600 people will die [78%]

Which of the two programs in each problem would you favor?

To understand loss aversion, we must understand Kahneman and Tversky’s (1979) prospect theory, in which the importance of loss aversion to human decision making was recognised, and made a central part of their theory. Prospect theory was proposed to challenge the extensively held normative theory of expected utility by Daniel Bernoulli (1738), which in summary hypothesised that human decision making is rational (Kahneman and Tversky, 1979; Kahneman and Tversky, 1992; Bernoulli, 1954; Briggs, 2014). Prospect theory explains how individuals form decisions about prospects (gambles). It is how individuals choose between alternatives when the outcomes connected with those alternatives involve risk and are probabilistic or uncertain in nature (Kahneman and Tversky, 1979). It has become a very practical and useful theory to describe the irrational way people process information, make decisions and behave, valuing gains and losses differently. According to expected utility theory, no sane individual would play the lottery or gamble with poor odds. However, Kahneman and Tversky (1992) revised prospect theory found that when people are faced with the same outcome but framed in two different ways (potentially win vs. potentially lose), people are more likely to choose the positively framed version even though the expected distribution is 50/50. Therefore, by including concepts such as loss aversion, Kahneman and Tversky (1992) have shown that people will make consistent decisions based on probabilistic alternatives.

The Asian disease experiment was used by Kahneman and Tversky (1981) to explain that people do not always make rational decisions. In the expected utility theory, it is assumed that people would not have a preference between choices in programs A&B or C&D because the choices are the same. However, prospect theory shows that there is a preference in our choices and that we value gains and losses differently, and that we are less willing to gamble with profits than with losses. The result of these choices are also due to the way in which the problems are framed. All programs were the same, but the frames were changed to a loss or gain. This showed that when peoples decision making and behaviour changed they value losses and gains differently.

People refer certainty (a sure thing) rather than risk losing it all for something better.

“A bird in the hand is worth two in the bush”

Certainty effect

Certainty (Kahneman & Tversky, 1986, pg. S266)

Which of the following options do you prefer? (N=77)

A. a sure gain of $30 [78%]
B. 80% chance to win $45 and 20% chance to win nothing [22%]

Which of the following options do you prefer? (N=81)

C. 25% chance to win $30 and 75% chance to win nothing [42%]
D. 20% chance to win $45 and 80% chance to win nothing [58%]

Prospect theory involves the certainty effect, in which probable outcomes are given less weight in comparison with outcomes with certainty. This effect is a psychological phenomenon that people get tricked into by perceiving a certain benefit rather than taking a potential profit that is not certain. This effect as related to prospect theory is based on, and leads to, a tendency for people to avoid risk (risk aversion) in decisions involving sure (certain) gains and risk seeking in decisions involving sure (certain) losses (Tversky and Kahneman, 1986).

In the certainty example given above by Kahneman and Tversky (1986), found that the majority of participants who were presented the first option (A&B) chose option A even though the expected value of B ($45x0.8=$36) exceeds that of A by 20% ($36/$30=1.2). This validates the risk-aversion tendency that people show prospect theory. We are more likely to avoid risk and go for the option that is 100% certain. Further, when presented the second option (C&D), the majority of participants chose option D over C even though the expected value of the first option ($30x0.25=$7.50) was 20% lower than B ($45x0.2=$9.00). As neither of these options were a sure thing, we became more risk seeking.

Additionally, (Li and Chapman, 2009) found that people overweight certainty and it makes people prefer a reference point of 100% relative to other percentages, even though 100% may be an illusion of certainty. For example, experiments that frame a decision between receiving $4000 with probability 0.8 and $3000 with certainty, more people (80%) will choose to take the second option of $3000 (Kahneman and Tversky, 1979; Cerreia-Vioglio, Dillenberger, and Ortoleva, 2015). This risk averse decision is a good example of the certainty effect and how people make economically irrational decisions. Arkes argues that we use less time in processing certainty than we do in processing other probabilities (1991, as cited in Li and Chapman, 2009). People avoid risk when another option results in a sure thing.

“Not to be absolutely certain is, I think, one of the essential things in rationality” - Bertrand Russell, 1947

Framing effect

Framing effects are used in prospect theory to explain individual’s irrational decision making (Kahneman and Tversky, 2000). The effect demonstrates how people make decisions depending on how a problem is presented (framed). For example, as a loss or as a gain. A framing effect occurs when different words or phrases cause individuals to alter their preferences even though they may be logically equivalent (Cheung and Mikels, 2011). People reject a program when told that it will result in 5% more noise pollution and prefer a choice framed in keeping the environmental quality at 95% (Asgary and Levy, 2009).

Much like in the Asian disease problem given in prospect theory. When participants are presented with the likelihood of lives saved (positive frame/gain) or the likelihood of lives lost (negative frame/loss). The results indicated that the attractiveness of decisions vary when the same problem is framed in different ways (Kahneman and Tversky, 1979). It appears that people exhibit a tendency to be risk averse when presented with positively framed problems and risk seeking when confronted with negatively framed problems (Gonzalez, Dana, Koshino, and Just, 2005).

"It ain't what you say, it's the way that you say it".

Loss aversion

The over-arching theme of all of the above is loss aversion. Loss aversion is one of the important implications of prospect theory (Kahneman and Tversky, 1979). When a person is presented with two choices, one as gains and the other as possible losses, they are more likely to choose the choice framed as gains over losses even though the expected value results of both may be the same (Kahneman and Tversky, 1992). The pain of losing hurts more than gains, therefore we seek to avoid negative situations leading to risk aversion in gain scenarios and risk seeking in loss decisions.

Contrary to the normative expected utility theory which implies that people are rational and logical in their decision making process, loss aversion shows that people process information in an illogical way by valuing gains and losses differently. People dislike losses so much they make irrational decisions to avoid them. Technically we should be happy if we were given $50 OR we were given $100 and then lost $50. Both are $50 gains. Prospect theory, with an emphasis on loss aversion, demonstrates that people who simply received the single $50 gain viewed this more positively than the gain of $100 and then a loss of $50. Resulting because the feeling of pain due to a loss hurts twice as much than a gain.

Loss does hurt but if we can learn to change our perspective we can start enjoying the wins too.

"I hate to lose more than I love to win - Jimmy Connors".

Quiz: True or False?

Conclusion

The general population may assume that we make logical judgement and rational decisions. Several researchers, including Kahneman and Tversky (1979; 1986; 1992) challenged this assumption and found evidence to suggest that human decision making is actually consistently and predictably illogical. Many of our everyday decisions involve both probable gains, but also probable losses. The majority of people when making decisions exhibit what is known as loss aversion. That is, the pain of loss is much greater than the pleasure we may feel from gains of the equal size. When given a gamble with a 50% chance of either winning or losing money of the equivalent value people generally reject the gamble unless the gain is at least twice the amount of the potential loss (Kahneman and Tversky, 1979; Gachter, Johnston and Herrman, 2010). Loss aversion is a concept associated with prospect theory and is commonly quoted as “losses loom larger than gains” (Kahneman & Tversky, 1979). Loss aversion has been used to explain the endowment effect, sunk cost fallacy, status quo bias and framing effect. As people are more willing to take risks to avoid a loss, loss aversion can explain differences in risk-seeking versus aversion. When something is framed as a gain, people tend to show risk-averse behaviour; and when framed as a loss they show risk seeking behaviour. Loss averse investors are quick to lock in investment gains (risk averse) and hold on to their losing positions (risk seeking).

The principle of loss aversion is a complex behavioural-cognitive bias in which individuals show both risk aversion and risk seeking behaviour. These behaviours can have a variety of consequences and it would help to avoid these to start making and valuing gains. Loss aversion is not just a habitual behaviour but a occurrence in human psychology. Understanding loss aversion and its effect on one's behaviour will allow one to avoid most of the biases associated with loss aversion and make smart and rational decisions.

References

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Braverman, J., & Blumenthal-Barby, J. (2012). Assessment of the sunk-cost effect in clinical decision-making. Social Science & Medicine, 75(1), 186-192. doi:https://doi.org/10.1016/j.socscimed.2012.03.006

Bucher-Koenen, T., & Ziegelmeyer, M. (2011). Who lost the most? Financial literacy, cognitive abilities, and the financial crisis. European Central Bank, 54(1299), 4-40. Retrieved from https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1299.pdf?ce13373f9d7d8fc4eb2fffe7e04582b9

Garland, H. (1990). Throwing good money after bad: The effect of sunk costs on the decision to escalate commitment to an ongoing project. Journal of Applied Psychology, 75(6), 728-731. doi:http://dx.doi.org/10.1037/0021-9010.75.6.728

Guillemette, M., Yao, R., & James, R. (2015). An analysis of risk assessment questions based on loss-averse preferences. Journal of Financial Counseling and Planning, 26(1), 1729. doi:10.1891/1052-3073.26.1.17

Haigh, M., & List, J. (2005). Do professional traders exhibit myopic loss Aversion? An experimental analysis. The Journal of Finance, 60(1), 523-534. doi:https://doi.org/10.1111/j.1540-6261.2005.00737.x

Kahneman, D. (2011). Thinking, fast and slow. New York: Farrar, Straus & Giroux

Kahneman, D., & Lovallo, D. (1993). Timid choices and bold forecasts: A cognitive perspective on risk taking. Management Science, 39(1), 17-31. doi:http://dx.doi.org/10.1287/mnsc.39.1.17

Kahneman, D., & Tversky, A. (1979). Prosepct thoery: An analysis of decision under risk. Econometrica, 47(4), 263-291. doi:doi:10.2307/1914185

Kahneman, D., & Tversky, A. (1981). The framing of decisions and the psychology of choice. Science, 211(4481), 453-458. doi:http://dx.doi.org/10.1126/science.7455683

Kahneman, D., Knetsch, J., & Thaler, R. (1990). Experimental tests of the endowment effect and the coarse theorem. Journal of Political Economics, 98(6), 1325-1348. doi:10.1086/261737

Kahneman, D., Knetsch, J., & Thaler, R. (1991). The endowment effect, loss aversion, and status quo bias. Journal of Economics, 5(1), 193-206. doi:10.1257/jep.5.1.193

List, J. (2003). Does market experience eliminate market anomalies? The Quarterly Journal of Economics, 118(1), 41-71. doi:https://doi.org/10.1162/00335530360535144

List, J. (2004). Neoclassical theory versus prospect theory: Evidence from the marketplace. Econometrica, 72(2), 615-625. doi:https://doi.org/10.1111/j.1468-0262.2004.00502.x

Morewedge, C., & Giblin, C. (2015). Explanation of the endowment effect: An integrative review. Trends in Cognitive Science, 19(6), 339-348. doi:10.1016/j.tics.2015.04.004

Morewedge, C., Shu, L., Gilbert, D., & Wilson, T. (2009). Bad riddance or good rubbish? Ownership and not loss aversion causes the endowment effect. Journal of Experimental Social Psychology, 45(4), 947-951. doi:doi:10.1016/j.jesp.2009.05.014

Samuelson, W., & Zeckhauser, R. (1988). Status quo bias in decision making. Journal of Risk and Uncertainty, 1(1), 7-59. doi:https://doi.org/10.1007/BF00055564

Sokol-Hessner, P., Hsu, M., Curley, N., Delgado, M., Camerer, C., & Phelps, E. (2009). Thinking like a trader selectively reduces individuals' loss aversion. Proceedings of the National Academy of Sciences of the United States of America, 106(13), 5035-5040. doi:https://doi.org/10.1073/pnas.0806761106

Thaler, R. (1980). Toward a positive theory of consumer choice. Journal of Economic Behavior and Organization, 1(1), 39-60. doi:https://doi.org/10.1016/0167-2681(80)90051-7

Tovar, P. (2009). The effects of loss aversion on trade policy: Theory and evidence. Journal of International Economics, 78(1), 154-167. doi:https://doi.org/10.1016/j.jinteco.2009.01.012

Tversky, A., & Kahneman, D. (1992). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and Uncertainty, 5(4), 297-323. doi:https://doi.org/10.1007/BF00122574

Yao, R., & Lei, S. (2015). Factors related to making investment mistakes in a down market. Journal of Personal Finance, 14(2), 34-42. Retrieved from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2740022

External links

Behavioural Economist Dan Ariely on loss aversion and the endowment effect (YouTube)

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