Loss aversion bias – the irrational belief that losses are bigger than similar-sized gains –can be influential in economics and investment.
Loss aversion bias affects all decision making, but is often more pronounced when your personal hard-earned money is at stake.
The psychology behind ‘behavioural bias’ is extensive. There are plenty of biases that throw up systematic deviations from rational thought and spoil good investment decisions. Others include attribute substitution, over confidence, herd bias and cognitive dissonance.
I will be irrational to avoid any sort of loss
Loss aversion bias involves people trying to evaluate an outcome that potentially offers similar gains and losses.
Research has shown that humans, in weighing up the two equal options – loss or gain – strongly prefer avoiding losses to making gains. For them, ‘losses loom larger than gains’. People don’t like losing.
A feeling among psychology and economics academics is that, if we can answer the questions to do with decision making, then we will have a greater understanding, more success and less failure in economics, finance and daily life.
Loss aversion bias is a common condition
Cognitive bias is when someone thinks before they act. Emotional bias is more spontaneous.
Cognitive loss aversion bias is illustrated by reference to facts that could be repeated: “Do you remember that holiday in Sardinia when we had a nightmare with the mosquitoes? Let’s not go there again.”
An example of emotional loss aversion is when a trader cannot believe a bull market will continue upwards because they remember that when the last bull market turned, they made losses.
In this case, the trader knows that what happens in the past does not predict the future, but their instinct is loss aversion bias and it is often too strong to resist. They sell the shares for fear of losing.
Investing: fighting those tempting biases. Souce Shutterstock.
In this case, the trader knows that what happens in the past does not predict the future, but their instinct is aversion bias and it is often too strong to resist. They sell the worthwhile shares now for fear of losing out in an uncertain future.
The theory that made theoretical economists think again
Theories of behavioural economics and finance abound. Economist Richard Thaler who wrote Quasi-rational Economics in 1991, thought that the mistakes we make all the time are due in part to ‘routine bias’.