Loss aversion

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Loss aversion is a concept in psychology. It is to prefer avoiding losses to acquiring equivalent gains. The principle is prominent in economics.

The principle of loss aversion was first proposed by Daniel Kahneman and Amos Tversky in 1979.[1] Loss aversion happens when people face the same amount of gains and losses and find the loss is more unbearable. In other words, the pain of loss is greater than the pleasure of equal gain. In some experiments, it shows females have a higher level of loss aversion than males.

Affective Science and Neural basis[change | change source]

The cause of loss aversion lies in people's asymmetric emotional response to gain and loss. Studies show that this asymmetry is particularly strong during the anticipation processing and the immediate experience after presenting the outcome. One study of income and well-being indicates that when people make loss-averse choices, it is not directly due to the loss itself but because the impact brings a series of negative consequences that follow the loss.[2]A classic example presented in the book "Thinking, Fast and Slow" of a flipping coin implies that people will first compare the satisfaction of gaining with the pain of losing before making a decision. Thus, most people would not choose to participate in coin gambling with 50% to get $150 and 50% to lose $100; and according to the "loss aversion ratio," the minimum amount to fulfil the pain of losing $100 will be $200 (assume the coefficient is 2).[3]

In 2001, J. O' Doherty and his colleagues had found that humans process losses and gains in qualitatively different ways by using brain imaging technology and suggests the correlation between the magnitude of brain activation and the extent of reward and losses received.[4]When we are evaluating potential gains, the areas of the brain that process value and reward become more active than it does when assessing the potential losses. The different loss aversion levels differ from individuals by the degrees of sensitivity to losses and gains, in which people are more loss-averse with stronger sensitivity.[5]

Supports[6][change | change source]

Equity premium puzzle[change | change source]

Equity premium puzzle(EPP) refers to the problem of why there is a big difference between returns in stocks and risk-free investments historically. Since stocks are much riskier than government bonds, the underinvestment in stocks relative to bonds supports the idea of loss aversion theory. Specifically, it's the myopic loss aversion introduced by Shlomo Benartzi and Richard Thaler,[7] which indicates the behavioural characteristics of "loss aversion" and "frequent evaluations" of investors. Benartzi and Thaler argue that loss-averse investors are more willing to take risks if they do not evaluate the performance of their investments frequently. In their model, investors are unwilling to accept return variability and tend to take a short-term view of their wealth.

Demand elasticity[change | change source]

Demand is more elastic for price increases than price decreases, based on the assumption that the price increase is a loss while the price decrease is a gain for consumers.

Daniel Kahneman's contributions[change | change source]

Prospect theory[change | change source]

Based on the principle of loss aversion, Daniel Kahneman and Amos Twersky developed prospect theory to explain how consumers make decisions in uncertain situations. Unlike the hypothesis of rational man use in economics, prospect theory reveals the irrational psychological factors that affect the choice behaviour. Most people are unwilling to take risks when facing gains but become risk-seeking in losses.

Endowment effect[8][change | change source]

Loss aversion theory explains the endowment effect. The endowment effect refers to the finding that once an individual owns a good, he/she tends to naturally place more value than he did before he didn't own it. Due to the asymmetric responses to losses and gains in the decision-making process, the consideration of "loss avoidance" is far greater than that of "gain seeking," so people value more on a good they own.

Real world applications: Marketing Strategy[change | change source]

By using the loss aversion theory as a marketing strategy, firms are able to gain higher profits by changing consumers' behaviours. For example:

  • Free trials. It leads users to subscribe to avert the loss once people establish ownership.
  • Cart abandonment notifications. The language uses here of "you left in your cart" makes consumers have a kind of "this item already belongs to me" illusion. Loss aversion might happen.
  • Return systems
  • Reward systems
  • Above a certain amount of money, to get a free shipping fee,etc.

References[change | change source]

  1. Kahneman, Daniel; Tversky, Amos (1979). "Prospect Theory: An Analysis of Decision under Risk". Econometrica. 47 (2): 263–291. doi:10.2307/1914185. ISSN 0012-9682. JSTOR 1914185.
  2. Sokol-Hessner, Peter; Rutledge, Robb B. (2018-11-29). "The Psychological and Neural Basis of Loss Aversion". Current Directions in Psychological Science. 28: 20–27. doi:10.1177/0963721418806510. S2CID 149792959.
  3. "Kortext". read.kortext.com. Retrieved 2021-02-17.
  4. O'Doherty, J.; Kringelbach, M. L.; Rolls, E. T.; Hornak, J.; Andrews, C. (January 2001). "Abstract reward and punishment representations in the human orbitofrontal cortex". Nature Neuroscience. 4 (1): 95–102. doi:10.1038/82959. ISSN 1546-1726. PMID 11135651. S2CID 52848707.
  5. Tom, Sabrina M.; Fox, Craig R.; Trepel, Christopher; Poldrack, Russell A. (2007-01-26). "The Neural Basis of Loss Aversion in Decision-Making Under Risk". Science. 315 (5811): 515–518. Bibcode:2007Sci...315..515T. doi:10.1126/science.1134239. ISSN 0036-8075. PMID 17255512. S2CID 10102114.
  6. Gal, David; Rucker, Derek D. (2018). "The Loss of Loss Aversion: Will It Loom Larger Than Its Gain?". Journal of Consumer Psychology. 28 (3): 497–516. doi:10.1002/jcpy.1047. ISSN 1532-7663. S2CID 148956334.
  7. Benartzi, Shlomo; Thaler, Richard H. (1995-02-01). "Myopic Loss Aversion and the Equity Premium Puzzle". The Quarterly Journal of Economics. 110 (1): 73–92. doi:10.2307/2118511. ISSN 0033-5533. JSTOR 2118511. S2CID 55030273.
  8. Kahneman, Daniel; Knetsch, Jack L.; Thaler, Richard H. (March 1991). "Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias". Journal of Economic Perspectives. 5 (1): 193–206. doi:10.1257/jep.5.1.193. ISSN 0895-3309.