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’.
“We make mistakes”, said Thaler and co-author Cass Sunstein, in their book Nudge: Improving Decisions About Health, Wealth and Happiness (2008), because, "we all are susceptible to a wide array of routine biases that can lead to …blunders in education, personal finance, health care, mortgages and credit cards, happiness, and even the planet itself."
But Thaler’s questioning of the bastions of economic theory – the concept that people always made rational decisions – slowly made an impact. He suggested that they were in fact deeply affected by all sorts of irrational biases, particularly loss aversion bias.
Loss aversion was formalised in ‘prospect theory’, an analysis of decision making, developed by Daniel Kahneman and Amos Tversky in 1979. In 2002, Kahneman won the Nobel Prize for this work.
We are rational only some of the time
Conventional economists assumed that decision making was part of an in-built logic. Their theories and models were based on an imaginary world where people were rational and made decisions without emotion and with total self-control.
Behavioural psychologists Kahneman and Tversky showed that people’s decisions weren’t always rational and they made mistakes thanks to embedded biases.
Prospect theory states that we assess gains and losses differently, and often base decisions on what we see as possible gains rather than perceived losses. With two equal choices people intend to choose gains, even when the choices produce the same economic outcome.
It is thought that the pain of losing is psychologically about twice as powerful as the pleasure of gaining. We will try to avoid a loss more than we will try to pursue a similar gain. That is crux of loss aversion bias.
A hedge fund manager, deciding where to place a fund’s cash, may have a strong desire not to choose a particular stock if they had invested unsatisfactorily in that sector before.
Daniel Kahneman, Nobel Prize winner. Source Flickr: Buster Benson.
Kahneman and Tversky suggested that it was possible to show that such biased decision making followed systematic patterns influlenced by data from the past and present
Extended to the world of marketing and retail, sales staff know that you can skew the wording of advertisements with, for example, tempting discounts or savings on postage and packing, so that a consumer may be encouraged to take a risk and buy when the deal is presented as a gain, rather than when it is presented as a loss.
Managing adverse bias is hard
Everyone, to a greater or less extent, whether they are economists, members of financial institutions or market traders, is aware of bias, and the wish to avoid possible mistakes is strong.
The most valuable skill, say seasoned investors, is to make rules about decision making and stick to them, changing the rules if necessary but never being without them. Through adherence to this simple, but hard to follow code, investors can reduce the risk of falling victim to all trading biases, not just loss aversion bias.