Loss aversion: taming the fear of loss for smarter decisions
We tend to be more driven to avoid losses than to achieve gains.
Problem 1. Which do you choose?
Get 900 euro for sure OR 90% chance to get 1200 euro.
Problem 2. Which do you choose?
Lose 900 euro for sure OR 90% chance to lose 1200 euro.
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Loss aversion is our tendency to prefer to avoid losses rather than achieve equivalent gains. We tend to feel the pain of losing something more intensely than the pleasure of gaining the same thing.
This innate asymmetry has an evolutionary history. Organisms that view threats as more urgent than opportunities have a better chance of surviving and reproducing. Increases in resources are helpful, but decreases in resources can be fatal. People differ in their individual levels of loss aversion, because variation is the engine of natural selection.
Loss aversion is one of the many manifestations of a broad negativity bias.
The expected value of the gamble in the above problems is:
90% chance to win 1200 euro and 10% chance to win 0 euro = 0.9 * 1200 + 0.1 * 0 = 1080 euro.
In the first problem, you probably chose the sure option even though the monetary benefit of the sure option is less than the expected monetary benefit of the gamble. Most people dislike risk, which in this case is the chance of receiving the lowest possible outcome (nothing). Risk averse decision makers will choose the sure option over the gamble with the higher expected value, meaning they are willing to pay a premium to avoid the uncertainty.
In the second problem, you probably chose the gamble even though the expected monetary loss of the gamble is greater than the monetary loss of the sure option. For people who choose the gamble, the pain of losing 900 euro is more than 90% of the pain of losing 1080 euro. Most people are likely to take their chances when faced with bad options, as we detest sure losses. People become risk seeking when all their options are bad.
People’s choices are not based on monetary values, but on the psychological values of gains and losses. Loss aversion is our tendency to respond stronger to losses than to corresponding gains. Our aversion to losing is greater than our preference for winning. Losses outweigh gains.
Many of the options we face in life have a risk of loss (defeat) and an opportunity for gain (victory). Consider the following problem as a simple example of mixed prospects.
Problem 3: You are offered a gamble by tossing a coin.
If the coin shows tails, you lose 100 euro.
If the coin shows heads, you win 150 euro.
Will you accept this gamble?
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The expected value of the gamble is positive, but you probably don't take the gamble because the fear of losing 100 euro is greater than the hope of winning 150 euro. Various experiments have estimated that to accept this gamble, people would have to win on average 150 to 250 euro if the coin shows heads.
Implications of loss aversion
Loss aversion strongly biases our choices in favour of the current situation (the status quo), because changes for the worse are seen as losses, and losses outweigh gains. Loss aversion is a conservative force that helps us remain stable in our marriage and job.
The asymmetric intensity to avoid losses and achieve gains is evident almost everywhere.
👉 When faced with the choice of selling a stock at a loss, many investors often hold on to it in the hope that it will recover. This unwillingness to accept a loss can lead to significant financial losses over time.
👉 Loss aversion makes people risk averse. They tend to choose safer options, often with lower rewards, rather than taking calculated risks. For example, people may prefer savings accounts with lower interest rates over riskier investments with higher returns, out of fear of potential losses. Employees tend to avoid risk because the potential gain of a bonus does not outweigh the potential loss of their job.
👉 The endowment effect is our tendency to value items we physically own more highly than equivalent items we do not own. When we sell something we own, we usually want more money for it than we were willing to pay for it. For instance, this can apply to a ticket for a sold-out concert, our house, or personal belongings such as jewellery. This tendency leads us to overvalue objects simply because we possess them, making us hesitant to part with these possessions. When we own something, we focus on the pain of losing it, whereas when we don't own something, we focus on the pleasure of acquiring it. Loss aversion makes the pain of giving up something stronger than the pleasure of getting it.
👉 To persuade people, it's often more effective to emphasize the avoidance of a potential loss rather than highlighting a possible gain. For example, instead of saying, "Exercising regularly can help you remain healthy," say, "Exercising regularly can help you avoid serious health issues." Similarly, instead of saying, "Investing in this plan can increase your wealth," say, "Investing in this plan can protect you from future financial instability."
👉 In negotiations, concessions are seen as losses by the party making them and as gains by the party receiving them. Loss aversion creates an asymmetry that makes it difficult to reach agreements. Negotiations over a shrinking pie are particularly difficult because they require an allocation of losses. Negotiators often pretend to have a strong attachment to something that they ultimately intend to give away in an exchange. They present their concession as painful in order to get the other party to make an equally painful concession (which may of course also be fake).
👉 Animals, including humans, fight harder to avoid losses than to achieve gains. Corporate reorganisations and legislative reforms create winners and losers. Potential losers will be more active and determined than potential winners. The result will be biased in their favour and end up more expensive and less effective than planned. Reforms often contain grandfather clauses that protect current stakeholders.
👉 Investors can improve their efficiency and emotional well-being by checking less often how well their investments are doing. Constantly tracking daily fluctuations is a recipe for mental suffering, because the pain of frequent small losses outweighs the pleasure of the equally frequent small gains.
How to reduce the impact of loss aversion
Protecting yourself from the negative consequences of biases can be tiresome, but it can be worth it when the stakes are high.
⚒️ Become aware of loss aversion
Becoming aware of the potential influence of loss aversion is the first step in mitigating its impact.
When making an important decision, take a step back to consider whether loss aversion might be influencing your choice. Reflect on questions such as:
🤔 To what extent is my decision driven by fear of loss? Identify if your fear of losing something is overshadowing other important factors in your decision-making.
🤔 Am I overly attached to the current situation, even if it’s not optimal? Evaluate whether emotional attachment to your current situation is preventing you from making a better choice.
🤔 Have I thoroughly assessed the potential risks and benefits? Carefully consider both the positive and negative aspects of your options.
🤔 Am I overly focused on short-term losses instead of my long-term goals? Think about whether immediate losses are distracting you from achieving your long-term objectives.
🤔 What would I choose if I wasn't afraid of losing? Envision your decision-making process without the influence of fear, helping you make a more balanced choice.
If you become aware that loss aversion may be playing a role, use techniques that can reduce its impact.
⚒️ Use decision criteria
Develop a set of decision criteria or guidelines for making choices. Adhering to these criteria will make it easier to separate emotions from the decision-making process. For example, establish decision criteria for selling shares, such as a predetermined percentage loss or a specific time horizon. If a stock meets these criteria, you commit to selling regardless of your aversion to losses.
⚒️ Use risk policies
Define risk policies that will almost certainly be financially beneficial in the long term. For example, always take the highest possible deductible when taking out insurance, or never buy extended warranties. Apply your risk policy routinely rather than establishing a preference every time you face a risky choice. Having policies that are beneficial in the long run reduces the pain of the occasional losses.
⚒️ Prospect framing
Reframe your decisions in terms of potential gains rather than potential losses. By changing your perspective, you can reduce the emotional impact of loss aversion. For example, if you are considering to purchase a new product or service that you can afford, focus on the benefits and improvements it will bring to your life. Emphasise the features that will enhance your life experience, rather than dwelling on the costs. When making lifestyle changes, frame your choices as opportunities to improve your well-being, feel more energetic, and enjoy a higher quality of life.
⚒️ Align choices with your life purpose and personal values
When you make choices that align with your deeply held personal values and life purpose, you are more likely to prioritise long-term goals over the fear of short-term loss. For example, if one of your core values is financial security, you may be more inclined to make investment decisions that prioritise a diversified and balanced portfolio, even if it means accepting short-term losses for long-term stability. Valuing personal growth and lifelong learning can motivate you to invest in educational opportunities and personal development, even if this comes with initial costs and potential short-term losses.
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Understanding and addressing loss aversion is crucial to making better decisions that align with our life purpose and personal values. While we may never completely eliminate irrational fears of loss, we can learn to manage and harness them, allowing us to make decisions that ultimately lead to a more meaningful and fulfilling life.
References
Thinking, Fast and Slow, by Daniel Kahneman
5 Common Mental Errors That Sway You From Making Good Decisions, by James Clear,
https://jamesclear.com/common-mental-errors
What Is Loss Aversion?, Psychology Today, by Shahram Heshmat Ph.D.,
https://www.psychologytoday.com/intl/blog/science-choice/201803/what-is-loss-aversion
My blogposts about biases and heuristics are available here:
https://www.a3lifedesign.com/blog-english/category/Biases
