Loss Aversion Explained!

Loss Aversion Explained

So, would you rather earn $90,00,000 and escape taxes or earn $1,00,00,000 and give 10% of it as tax?

Pretty obvious huh, the first one! After all, if there is an option to avoid taxes, which idiot in the world would not choose that! But evidently, both scenarios make you end up with the same amount of money. It’s like I asked you to choose an apple from a basket full of identical apples. This is not even a comparison, yet most of us show an inclination towards preferring to earn 9 million dollars and escaping the taxes. 

Okay, one more time, you bought a condo for $200,000 in Texas and now you are moving to Virginia for a new job. Would you sell your house at today’s price of $140,000?

Am I crazy to even ask that question? Maybe. Well, all these choices are catalogued under what is called “Loss Aversion”. The $140,000 might help you start a better life in Virginia, and the nice condo of yours will only turn more dilapidated with each year you decide not to sell because the market price is low. Yet not just you, most people will cling onto the condo in the hope of a high market price in future.

Coined by Daniel Kahneman and his associate Amos Tversky in 1979 for a paper on subjective probability, the term “Loss aversion” is the tendency to prefer avoiding losses over acquiring equivalent gains. Kahneman later emphasised this cognitive bias in his “Thinking, Fast and Slow” in 2013.

Behavioural science suggests that the pain of loss overrides the happiness from gain, which implies a loss of $100 will crush you more than a $100 windfall will revive you.

A $30 product framed as  $5 discount on a $35 or a $25 with $5 surcharge, significantly affects consumer behaviour. An increase in price, bags more responsiveness than an exact decrease in the price does. The same phenomenon explains why penalty frames are more effective than reward frames in motivating people. Take, for example, one year, the teachers of a middle

school were Loss Aversion Explained!promised up to 5% bonus on final salary based on student’s end-of-the-year performances. The next year lump sum of 5% bonus was given at the beginning of the year, which needed to be paid back based on the end-of-the-year performances. Needless to say, academic records of the latter year were remarkably better. People simply don’t want to give up money, they think they already own!

In investment markets, ardent abstinence from losses, in fact, ends up causing more losses. Investors don’t acknowledge a loss as being such until it is realised and often hold onto losing investments so long that they end up suffering much bigger losses than necessary. You remember Dilbert right?!Loss Aversion Explained!

Did you know the “Free trial period” marketing strategy very much originates from the seeds of loss aversion? Having got used to a product/service, now consumers find it more reasonable to pay for it than to give it up. Again people simply don’t want to give up benefits, they think they already are used to!

By the way, what is your worst fear?

Losing something or someone? You are not alone my friend, the fear of loss is the most prominent fear to hold back you, me and almost everyone out there. Loss aversion not only dominates financial decisions but reasons out your sticking with a long-married partner even in a failing and unhappy relationship. The mere thought of losing something that you own- materialistic or your ideas, get you rolling to do whatever it takes to avoid it. We feel invested in our opinions and hence don’t want anything to let go! 

People have soft corners for themselves; they tend to value their choices even if it’s an irrational one and devalue the road not taken. In fact, from a broader perspective, Stoic philosophy suggests if we have lost someone or something precious, we might deal with it by imagining that we never knew that person, or never owned that object in the first place! 

And being wealthy only makes it worse. You guessed it right, the pain of losing fortune exceeds the emotional gain of getting additional wealth and the well-to-do end up being more vulnerable. 

Several theories team up with the principle of loss aversion to blindfold us into taking biased decisions. 

For instance, prospect theory assumes that losses and gains are valued differently, and we make decisions based on perceived gains instead of perceived losses.  The narrow framing from Prospect theory makes us more sensitive to stock market fluctuations as opposed to other aspects of our overall wealth like our labour income or the housing market. 

Did it ever occur to you that you will sell your favourite toy car, with which you have a ton of memories as a kid, at twice the price of an identical car? Well, of course, I understand, it was and still is your Mercedes W05! This attachment with our belongings makes us overvalue them. Because losing them feels like a loss and humans as we have been noticing for quite a while, are LOSS-AVERSE. This phenomenon is called the endowment effect

And finally, there is reference dependence, which is a core principle in behavioural economics. Nothing is absolute. I hope everyone would agree to that. So often with decisions involving risks and uncertainty, we tend to evaluate outcomes relative to a reference point. Strictly speaking, an endowment might deviate from the reference point representing a loss, and it might deviate by the same size but representing a gain. Guess where the subject value of change will be more significant? Former, of course. 

Before we wrap up, consider these questions:

Are there gender differences in loss aversion?

What is the role of experience?

According to gender similarity hypothesis, men and women are similar on most, but not all psychological variables. The gender difference in loss aversion may be driven by factors as: gambling aversion, mathematical efficacy issues, and financial risk-taking propensity. Historically gambling was considered a male activity and a 2006 study unveiled that women preferred slot machines over casino tables. Being a feminazi I hate to write this, but, women reporting low competence in topics involving mathematics and their overall reluctance to indulge in a dicey activity, are some hypotheses to reason out the difference.

For the second question, we have a couple of definitions; 

  1. House money effect: refers to a pattern whereby prior gains lead to greater risk taking and hence decreased loss aversion in subsequent periods. 
  2. Break even effect: The break-even effect results from a previous loss and increases the amount of risk someone will take. The urge to make up for the previous losses,  induces the risk of taking excessive risks and we witness an increased loss aversion.

But in general, loss aversion erodes as one accumulates more experience in their fields of operation. 

In a nutshell, loss aversion is an essential aspect of everyday economic life. People are not loss averse regarding all kinds of attributes and there are most probably different degrees of loss aversion, which can be compared across attributes. The loss aversion is a reflection of a general bias in human psychology (status quo bias) that makes people resistant to change unless they find a solid enough reason. So while evaluating implications of a change in our lives, we focus more on what we might lose than on what we might be gaining.  

Loss Aversion Explained

Can we dodge this cognitive bias?

Well here are some tips for you to help you make more reasonable decisions despite loss aversion hovering over your head;

  • Increase the likelihood and payoff of success
  • Another simple trick is to shift your focus away from the success or failure of each project, and instead focus on the overall impact. 
  • Instead of treating projects individually with a fully assigned budget, using principles like Lean Innovation Management make projects done faster, cheaper and with lower risk.
  • Digest that fact that losses and winnings are like the Yin and Yang of everyday trading
  • Always follow your plan and have an exit strategy hidden up your sleeve.

And finally, let’s not forget that the greatest risk is to not take any!

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