Behavioral New World
October 1, 2022
I originally wrote about loss aversion in the July 2020 newsletter. Remember, you have access to past newsletters in the Archive.
What is loss aversion? In short, it’s the tendency for us homo sapiens to have a greater sensitivity to losses than to gains. That is, losses hurt more than gains of the same magnitude. For example, few people would take a 50/50 gamble, say to win $100 or to lose $100. The possible gain of $100 feels inadequate to offset the equal possible loss of $100 – equal on paper that is, but not inside the boundaries of our minds and emotions.[1]
That should be enough right there to prove the existence of loss aversion. But, if you need it, there is a ton of further evidence produced in laboratory experiments over many decades, particularly concerning financial tradeoffs like that one. The results are clear: most people are willing to go to great lengths to avoid losing money. As we’ll see below though, loss aversion is not limited just to monetary outcomes.
Why does loss aversion exist? What purpose does it serve? A reasonable conjecture comes from evolutionary psychology. When life was much more precarious, negative outcomes (losses) could be fatal more frequently than today, at least in today’s developed world. There was an asymmetry between bad and good events.
Why is loss aversion important to understand? Because in your attempts to avoid pain, you can create more pain. Which is the exact opposite of what you intended. Let’s consider three financial implications.
1. Loss aversion can lead to a reluctance to sell a losing investment, even though it makes sense to sell from a tax (or other) perspective. Selling is the final realization that there has been a loss. Rather than sell, many people say to themselves, “I’ll hang on and sell when it gets back to the price I paid.” In the words of behavioral economics, they have “anchored” on the initial purchase price. And in this way, they don’t have to fully face up to the loss.
2. In contrast, when the stock market declines precipitously, some people sell all their risky assets (e.g., stocks) to avoid the future pain of losses. The current losses hurt, the anticipation of further losses also hurts, and investors want to put an end to the hurt. But this emotional reaction to losses sets them up for missing future gains.
3. Advice that follows from loss aversion: Don’t look at your investment portfolio too frequently—the losses will stand out in your mind more than the gains and that might lead you to abandon a well-formulated investment plan. A quarterly peek at your financial statements is probably OK.
Fun fact: monkeys exhibit loss aversion.[2] Here’s how researchers structured their study:
“The researchers introduced an element of choice into their experiment. They [the monkeys, not the researchers] could trade with one of two people. One would give them two pieces of food, grapes in this case, for their token, every time they traded. It was a no-lose, safe option.
But the other gave them either one grape or three grapes, in exchange for their token. The second deal carried more risk as half the time it was one grape, the other half three.
Translated into human terms, look at it like this: You have a choice, you could get a guaranteed $2000 or have a 50% chance of getting $1000 and a 50% chance of $3000.
To gamble or not to gamble - which option would you choose? Most people will go for the safe option - they take the $2000. That is also what monkeys do.”
This experiment is very much like the 50/50 gamble described above.
A second experiment in a different setting showed that the “…thought of losing out is so painful that they [the monkeys] will risk a bigger loss just for a chance of no loss,” also consistent with loss aversion.
Loss aversion is evident in settings other than money and grapes. Perhaps my favorite example is the case of football/soccer fans. They were asked by researchers to rate their happiness on days after their favorite team won and on days after which their favorite team lost. Perhaps not surprisingly, their happiness levels were substantially different on the two days. But the decline in happiness associated with losses was much bigger in magnitude than the increase in happiness associated with wins, consistent with loss aversion.[3]
Further, there is neurological evidence supporting the existence of loss aversion.[4] Like it or not, we share 99% of our genes, and hence our neurology, with monkeys and football fans.
What can we do about loss aversion if it is ingrained in our psyche?
We can try to change our mindset to evaluate gains and losses more rationally. Alan Watts suggests a Zen approach, in which one works to eliminate the notions of “good” and “bad.”[5] A strikingly similar approach comes from Stoicism, which argues that events are inherently neither good nor bad, but that we assign values to events. Both approaches try to reduce our emotional reaction to gains and losses.
Alternatively, you might consider putting a loss, realized or prospective, in context: Is the loss serious? Dale Carnegie suggested that we think about the worst possible outcome and prepare ourselves for it. Once we’re confident that we can survive the loss, then one can take actions to try to prevent the worst case from happening. If you can’t survive a potential loss (figuratively speaking at least), you are exposed to too much risk.
Now that you know loss aversion is indeed monkey business, and that you – unlike monkeys – can do something about it, I recommend you try some of the tips and ‘hacks’ above. See whether they work for you. What do you have to lose?
[1] In the spirit of open inquiry, note that some scholars are skeptical of the notion of loss aversion:
It might well be that loss aversion is present in some circumstances but not others, or perhaps varies over time. Culture may matter as well. More research will help clarify this issue. But Daniel Kahneman, grandfather of behavioral economics, has written, “…the concept of loss aversion is certainly the most significant contribution of psychology to behavioral economics.” Hard to ignore a Nobel Prize winner.
[2] For more detail, see https://www.bbc.com/worklife/article/20180406-what-monkeys-can-teach-us-about-money
[3] https://think.ing.com/articles/football-fandom-and-loss-aversion-a-paradox
[4] https://www.sciencedaily.com/releases/2010/02/100208154645.htm
[5] https://www.themarginalian.org/2015/11/06/alan-watts-swimming-headless/