Loss Aversion: What Is It and Why Should I Care?

Loss aversion is a concept I first learned about while reading Thinking Fast and Slow by Daniel Kahneman (an awesome book if you haven't already read it). Although we're all susceptible to loss aversion, having a general awareness of what it is will help us to spot loss aversion at play in real life. It can also help us to avoid traps set by this cognitive bias in our daily lives.

What Is Loss Aversion?

Loss aversion is a cognitive bias. It’s an asymmetry of risk that explains why we’re driven more strongly to avoid losses than we are to achieving equivalent gains. If we’re not aware of our inherent aversion to losses, we’ll make poorer decisions by taking less risk where the potential outcomes are in our favour.

Loss aversion explains why experiments have shown that most people would rather keep £100 they would otherwise have lost, than to randomly finding £100. This isn’t rational. A truly rational person would be indifferent between gaining £100 and not losing £100 they would otherwise have lost. They recognise that finding £100 puts the, in the same position as not losing £100 that they would otherwise have lost – in both cases, they're £100 up.

Our intuitive aversion to losses intrigued behaviour economists Daniel Kahneman and Amos Tversky. The pair spent a significant part of their careers studying this irrationality. After several decades of research, their ground-breaking paper estimated that the pain of losing is psychologically twice as powerful as the pleasure of an equivalent gain [1]. Kahneman was awarded a Nobel prize for this work. Amos wasn't awarded a Nobel prize as they aren't awarded posthumously.

I’ll illustrate the point that we react more sensitively toward a possible loss compared to a possible gain, using a simple example.

If I were to toss a coin and give you £100 if it lands on heads, but you need to give me £100 if it lands on tails. Would you take me on the offer?

You’re not alone if you say “no”. Physiological experiments have shown that over 80% of people would say no. If we didn’t suffer from loss aversion and people were entirely rational, you would expect 50% of people to take me on the offer.

Now let’s change the stakes a little bit. If I offered you £150 if you win, while you still only give me £100 if you lose. Would you take me up on the offer now? Although some will take me up on the offer, most people would again say “no”, even though they would be better off by taking the gamble. The reason they would turn the offer down is because the pain of losing £100 would be more painful than the pleasure of winning £150. This irrationality is precisely what loss aversion is. This simple example explains the asymmetry of risk inherent in loss aversion.

I would need to offer £200 if it lands on heads, to make the average person indifferent about the bet. Another way of saying this is that we need to find £200 to be compensated for the pain of losing £100, or that losses are psychologically twice as powerful as the pleasure of an equivalent gain.

The pain of losing is psychologically twice as powerful as the pleasure of an equivalent gain

The following graph depicts loss aversion, through how we evaluate this asymmetry of risk. It would help if you thought of the "reference point" as “utility” – an economist's proxy for happiness or satisfaction. Gaining £100 gives half the utility of the absolute of a £100 loss. Losses of the same amount are felt more. It’s irrational and leads to biases in our decision making.

In a more recent study by Simon Schindler and Stefan Pfattheicher, they find that people are more willing to take risks (or behave dishonestly) to avoid a loss than to make a gain [2]. They concluded that the tax returns of self-employed individuals are more likely to contain dishonest information. They discovered that the reason for this is because self-employed individuals were having to pay additional tax, while the employed individuals were receiving cash from the tax authority for overpaid taxes. Loss aversion was explained to be the reason behind the dishonest tax returns. The finding of this research is interesting for two reasons:

1. It confirms that we prefer to protect what we already have (avoid losing) than to go out and get more (risk-taking)
2. People are more willing to take risks to prevent losses than to win/gain

Economics vs Psychology

Despite Kahneman winning the Nobel prize in Economics, both he and Tversky identify as cognitive psychologists. And when it comes to understanding people, psychologists win. Psychologist offer insights into how we think, and thus are more accurate when it comes to predicting human behaviour.

I would define economics is the study of the world around you, while psychology is the study of yourself and others. Classical economic theory assumes that people are rational, while psychologists assume (and rightly so) that people are irrational – that we’re driven more by feelings and emotions than by data and logic. This attitude to people’s rationality is perhaps one of the most significant distinctions between traditional economics and psychology.

Before the ground-breaking research by Kahneman and Tversky, economists assumed that people are indifferent between gaining £100 or avoid losing £100 that we would otherwise have lost. Psychologists know that we need to be compensated £200 to comfort us from the pain of losing £100. Losses are twice as painful psychologically than equivalent gains.

Three Examples Explaining Why Losses Are Twice as Painful Psychologically Than Gains

Example 1

In scenario A and B below, rate how you would feel on a scale of -100 to 100, with -100 meaning a feeling of devastation, 100 being a feeling of euphoria, and 0 being neutral (or indifferent).

• Scenario A: You found £100 on an empty street
• Scenario B: You lost £100 within a minute of withdrawing it from the ATM

Chances are, your positive reaction to finding £100 (in absolute), is greater than your negative reaction to loosing £100. If the pain of scenario B is greater than the pleasure of scenario A, you’re experiencing loss aversion. You would prefer to protect yourself from a loss because losses are more painful than gains — highlighting why humans are generally risk-averse.

Example 2

• Option A: 50% chance of winning £1,000 and a 50% chance of winning £0
• Option B: A guaranteed win of £450

Between option A and option B, which would you prefer? Make a mental note of your choice.

Now consider option C and D. Which would you prefer?

• Option C: 50% chance of losing £1,000 and a 50% chance of losing £0
• Option D: Guaranteed loss of £450

If you’re like most people, you’ll select options B, and C. Options B and C are the worst possible combinations. You win only £450, but you’re expected to lose £500.

Option A and option D are the superior options. A gives you an estimated gain of £500, while D gives you an estimated loss of £450. Despite the superiority of option A and D, most will select options B and C, because they are not aware of their bias towards loss aversion.

Example 3

Would you prefer option 1 or option 2?

• Option 1: 10% chance to win £95 and a 90% chance to lose £5
• Option 2: Pay £5 to participate in a lottery that offers a 10% chance to win £100 and a 90% chance to win nothing

If you have a preference for either option 1 or 2, there is bias affecting your decision making and judgement. The expected gain in both situations is £5. Despite the exact same payoff, option 1 feels more comfortable than option 2 as option 2 almost gives a guaranteed loss that we'd rather avoid.

Why Do We Have an Aversion to Losses?

Psychologists believe loss aversion has given us an evolutionary advantage. We can think of it as a defence mechanism. Our mind has been shaped by evolution to pay more attention to risks than potential gains.

To our early ancestors living close to the edge of survival, failing to avoid risk almost certainly resulted in death. While spending energy and valuable resources to seek potential gains doesn’t guarantee survival. It would have been better to save our resources for survival than it is to use the resources to take a gamble on a potential reward.

For example, let us assume that one of your early ancestors was walking through the woods with a friend. Your early ancestor was a risk avoider, while their friend was a risk-taker. They heard faint rustles in the bushes, which 9 out of 10 times turns out to be a rabbit.  The risk-taking friend will have a nice lunch 9 out of 10 times, but gets eaten by a tiger on the 10th time. Game over and they won't have any more descendants. However, your risk-avoiding ancestor doesn't get a nice lunch 9 out of 10 times, but also remains alive – they would have again fleed on the 10th time when it did turn out to be a tiger. The person avoiding risks had a much better chance of survival and passing on genes, risk-avoiding becomes the dominant gene for survival and is passed on to their decedents. So our minds are wired in a way to relate risk-taking behaviour with a fear of the possibility of a life-threatening result.

This phenomenon isn’t unique to humans. Psychologists have also found similar traits in animals – they too fight harder to prevent losses than to achieve gains. Studies on capuchin monkeys show that “monkeys react rationally to price and wealth shocks, but, when faced with gambles, display hallmark, human-like biases that include loss aversion.” [3]

It appears that having an aversion to losses is nature’s subtle way of increasing our chances of survival. We’re genetically predisposed to avoiding risks, even when it’s not in our best interest.

This aversion to losses that are intrinsic to human behaviour means that calling out and penalising people for bad behaviour is more effective than rewarding people for good behaviour. It explains why we’re going to continue paying for subscription services (Netflix, Amazon Prime, Apple Music, etc.) once our initial free trial has expired, even though we don’t need or use the service. Even though we rarely use the service, we'd rather keep what we already have in case there's something we want to watch in future. This is a risk-avoidance strategy that is analogous to loss aversion.

“Loss aversion is a powerful conservative force that favours minimal changes from the status quo in the lives of both institutions and individuals.” - Daniel Kahneman

Identifying Loss Aversion and Making Better Rational Decisions

A good way to avoid having your judgement impaired by loss aversion is to consider the opposite or an alternative to a decision you’re about to make. If there is an asymmetry in the choices that you would make, then it’s likely that loss aversion is affecting your ability to make a rational decision. Let me give you an example of how this could work in practice.

Consider a situation where your phone contract is about to expire. Your mobile operator is offering you a sweet new deal. You can upgrade your phone to the latest model for only an extra £15 a month, up from your current deal of £30.

Most people may only consider the marginal cost of £15 and claim this to be an excellent deal for the latest model phone, thus accepting the offer.

Considering the opposite to identify whether or not there is an asymmetry in your decision making, means that the marginal cost is irrelevant.

You should be asking yourself “If I didn’t have a phone today, would I pay £45 a month for the latest phone?” If your answer is “no”, then there is an asymmetry in your decision making, and loss aversion is impairing your judgement and you are likely to make an irrational decision. The implication is that you’d be happy to pay the extra to upgrade your phone, but you wouldn’t pay the same amount if you didn’t own a phone in the first place.

Considering the opposite is the basis of the inversion technique. It turns the question around on its head, letting you evaluate your options. If your instinct is to proceed with option A, inversion means you need to consider why option B may actually be the better option. It helps with weighing up both sides of the argument, reducing bias and helping us make better decisions.

It's Good to Take Risks When the Odds Are Sacked in Our Favour

Loss aversion has significant practical implications as we take risks every single day. It's important to note that taking risks isn’t necessarily a bad thing to do. Often, it’s good, and sometimes it’s the best thing to do because the odds are heavily stacked in our favour. If we didn’t take risks, we’d never travel the world, eat delicious meals or meet lifelong partners.

Most of us are risk-averse and will generally choose the least risky option available. Yet we often have more to gain and are likely to be far better off in the long term by choosing riskier options. This is particularly true where there is an asymmetry of risk and we have little to lose. Young people should take more risks earlier in their lives, screw things up, get things wrong and learn from these experiences – but this is a topic for another day.

Accurate evaluation of risks (and limiting biases as much as possible) is essential to decision making. It’s where awareness of our natural aversion to losses can help.

"Not everything we do with the aim of making ourselves safer has that effect. Sometimes, knowing there are measures in place to protect us from harm can lead us to take greater risks and cancel out the benefits. This is known as risk compensation. Understanding how it affects our behavior helps us make the best possible decisions in an uncertain world."

— When Safety Proves Dangerous

Summary

Loss aversion adversely impacts our decision making, leading to irrationalities as we do not accurately evaluate risks. Instead of seeking potential gains, we naturally prefer to avoid losses. It also means that we often avoid taking risks that are heavily stacked in our favour.

By becoming aware of loss aversion, we're better able to evaluate risks. Knowing when it's impacting our decision making would also help to ensure that we make more rational decisions, based on the facts and information made available to us at that particular moment in time.

Footnotes

[1] Tversky, A. and Kahneman, D., 1992. Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and uncertainty, 5(4), pp.297-323.

[2] Schindler, S. and Pfattheicher, S., 2016. The frame of the game: Loss-framing increases dishonest behavior. Journal of Experimental Social Psychology, 69, pp.172-177.

[3] Silberberg, A., Roma, P. G., Huntsberry, M. E., Warren‐Boulton, F. R., Sakagami, T., Ruggiero, A. M., & Suomi, S. J. (2008). On loss aversion in capuchin monkeys. Journal of the Experimental Analysis of Behavior, 89(2), 145-155.

Subscribe below to receive new post updates the minute they are published. You will also receive my weekly newsletter, where I share interesting articles, books, quotes and lessons that I have learnt during the past week.