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Loss aversion(1)
July 1, 2020

 
You seem like a very rational person.  I can tell by the way you’re acting right now: You’ve decided to read this blog, probably with the notion that you might learn a thing or two.  That’s quite a rational course of action, I’d say (though I might be slightly biased about this).

But let’s put that rationality to a bit of a test, just for fun.  Consider this scenario: What if I pulled $1,000 out of my pocket, slapped it down on the table in front of you, and said “Here, take this – I had some extra greenbacks sitting around and don’t want them.”  Assuming you would accept this unexpected gift, you might find yourself rather pleased – and start to think about the nice things you could do with that money.

Consider an opposite situation.  Let’s say you open your paycheck and you notice that it’s $1,000 less this month than the last one.  You ask your boss about it, and turns out that a special one-off payroll tax was applied to everyone this month.  In a flash you’re $1,000 poorer.

Logic dictates that these are symmetrical events.  In one, you have a $1,000 gain; in the other, a $1,000 loss.  That’s a net zero position.  And in one you are somewhat pleased, and in the other you are – equally displeased?

Unlikely.  And here is where your – and my, and just about everyone’s – rationality goes awry.  Extensive research by behavioral economists and psychologists proves that most of the time these two events are quite different – not quantitatively, but qualitatively.  In short, we tend to emotionally experience the loss of such an amount far more than we enjoy the gain of the same amount.  Some researchers have even determined that the ratio is 2 to 1: we hate losing something twice as much as we enjoy gaining the same thing.  So that $1,000 hit to your paycheck actually feels like a $2,000 hit, whereas that $1,000 I gave you feels like, well, just $1,000.  How rational is that?

Not very, at least as rationality is portrayed in conventional economic models.  But that is the human condition, I’m afraid, even among the most thoughtful among us. 

Behavioral economists call this “loss aversion.”  And when you start looking for it, you will see it everywhere.  Look even closer, and often you will see important consequences flowing from this emotional condition – many of them deleterious, but not all.  
 
Consider your stock portfolio. The stock market is up and running about 250 business days in a year.  Suppose that a stock you own goes up on 135 of these days and down on 115 days, which is enough to generate a typical upward trend and a nice return on your money for the year. If you look at your portfolio every day, you will see more winning days (135) than losing days (115). 

But loss aversion means that the losses hurt more than the gains. So looking at your portfolio frequently, e.g., daily, is likely to leave you feeling worse off than if you were to look only occasionally – say, quarterly.  Here’s the problem, though: If you look daily (or more frequently—turn off the running feed on your computer screen!!), you will be tempted to sell on those days when the market is down, even though the long-run trend is up.(2) If you look less frequently, it is more likely that you will see gains, be less inclined to sell, and thus benefit from the long-term upward trend of stock prices.

Loss aversion is just not about the stock market: it seeps into nearly all aspects of life where there are gains and losses.  A recent study looked at  how loss aversion affects real estate prices. The authors summarize, “[W]e find that sellers facing nominal losses relative to their prior purchase prices attained higher selling prices than their counterparts.”(3) The pain of selling at a loss motivates the seller to ask for a higher price to at least reduce the magnitude of the loss and its accompanying pain.  Unlike frequent peeking at your investments, in this context, loss aversion is a good thing (for the seller).

How about the grocery store? Nudge author Cass Sunstein writes, “a 5-cent tax on the use of a grocery bag is likely to have a much greater effect than a 5-cent bonus for bringing one’s own bag.”(4) Why is that? The 5-cent bonus for bringing your own bag is akin to a gain. The 5-cent tax for not bringing your bag is akin to a loss of 5 cents. Loss aversion says that we will feel the loss (perhaps only subconsciously) more than we would the gain. Avoiding the loss (the 5-cent tax) thus incentivizes shoppers to bring their own bags. A wise friend of mine calls this phenomenon, “Being motivated in a positive way by negativity.”

And going even more far afield: loss aversion shows up in our dating habits. Yes, we spend more effort looking for “deal breakers” (negative traits) in a potential partner than we do looking for his or her positive qualities!(5)  The influence of loss aversion in the dating scene is most salient during the period in which we are seeking a partner.  To initiate a relationship is to begin investing in it.  Once the relationship has reached a certain level, the “investment” is substantial, and the very thought of potentially losing the relationship, should it not work out, can be quite painful.  Better to investigate possible deal breakers early (to the extent possible, of course) to avoid the loss of the relationship later, even if there are valid reasons for ending it.  Or so “reasons” the loss averse portion of our brains.

In short, loss aversion is an ingrained human tendency that influences decisions in all aspects of our lives. It can be helpful. For example, our fear of losing a bet about weight loss might increase our motivation to lose those 20 pounds. But in many cases, loss aversion is not helpful, as in the stock market example above.

Awareness of our tendency to loss aversion is the first step toward making better decisions in all dimensions of our lives. We cannot change our natural tendency to loss aversion, but, with awareness, we can change our behaviors and habits to minimize its negative effects and use it when it is to our advantage.  And what’s more rational than that? 
 
            Notes:
  1. Part of this newsletter is based on Chapter 3 of my book The Foolish Corner (available on Amazon).
  2. Stocks for the Long Run, 5th edition, by Jeremy Siegal, McGraw Hill, 2014.
  3. “Could Loss Aversion Retain on the Market? Evidence from the Hong Kong Property Market” by Ling Li and Wayne Xinwei Wan, University of Cambridge, Department of Land Economy, working paper, June 2020.
  4. See Nudge: Improving Decisions About Health, Wealth, and Happiness by Richard Thaler and Cass Sunstein, Penguin Group, 2009.
  5. https://www.psychologytoday.com/us/blog/feeling-smart/201511/loss-aversion-and-romance
 
 
 
 
Copyright © 2020 John S. Howe, All rights reserved.

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