What is Loss Aversion?

Loss aversion suggests that for individuals the pain of

losing is psychologically twice as powerful as the
pleasure of gaining.
Description
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In other words, losing something (an amount of money, an item, etc.)

feels worse than gaining the same thing. It is a simple, but powerful
bias that is is encapsulated in the expression “losses loom larger than
gains” (Kahneman & Tversky, 1979).

Demonstrated by Amos Tversky and Daniel Kahneman in 1992, the key

idea behind the loss-aversion bias is that people react differently to
positive and negative changes of their status-quo. More specifically,
losses are twice as powerful compared to equivalent gains. This idea is
one of the foundations of prospect theory. Prospect theory describes
how people choose between different prospective options and how
they estimate the perceived  likelihood of these different options. For
instance,  even though the likelihood of a costly event may be
miniscule, we would rather agree to a smaller, sure loss — such as in
the form of making a monthly or annual insurance payment — than
risk a large expense (Outreville, 1998).

Companies and organizations often use loss aversion to their

advantage. The information these organizations provide to the public
can play into people’s biases and persuade them to make a particular
decision. Insurance company websites will often display a long list of
unlikely, yet costly outcomes that we may encounter should we not
buy insurance (Outreville, 1998). This list of potential unfortunate
events primes us towards the preference of avoiding these large losses
and makes us forget about the small, but regular payments we would
need to make into the future to ensure insurance coverage. In turn,
loss-aversion helps explain the situations in which individuals display
risk-averse versus risk-seeking behavior.

Additionally, there are particularly relevant consequences of loss

aversion for financial decision-making. As discussed, people weight
potential costs and failures more heavily than potential benefits and
rewards. Thus, when making investment decisions, people more often
focus on the risks associated with an investment, rather than on the
potential gains. This can also lead to hyperfocusing on an investment
that has lost money, while ignoring others. Further, people may be
unwilling to make financial decisions that represent loss, such as selling
a stock or house that has fallen below the price at which it was
purchased, even though the decision itself may be the best option.

Another implication of loss aversion for behavioral finance is that price

increases hurt more than price decreases help. For example, economist
Daniel Putler found that, from July 1981 to July 1983, a 10% increase in
the price of eggs led to a 7.8% decrease in demand, whereas a 10%
decrease in the price of eggs led only to a 3.3% increase in demand.

Finally, loss aversion implies that scaling back is painful. When people
contemplate buying new things, such as purchasing a fancier car or
bigger house, they often tell themselves that they can always downsize
if they can no longer afford these luxuries in the future. However,
people underestimate how emotionally difficult this decision actually
is.
Loss aversion explains why people tend to overweight small
probabilities to guard against losses.
RELATED BIASES

 Pessimism bias
 Zero Risk Bias
 Regret Aversion
3 things you should know
1. People are more willing to take risks to avoid a loss, so loss
aversion can explain differences in risk-seeking versus aversive
behaviour (Schindler & Pfattheicher, 2016)
2. People would rather accept a small but certain reward over a
mere chance at a larger gain.
3. Loss aversion can explain why penalty frames are sometimes
more effective than reward frames in motivating people (Gächter
et al., 2009)
Example
For example, what would you choose: to receive a guaranteed
payment of $900 or take a 90% chance of winning $1000 (and a 10%
chance of winning 0)? Most people would decide to avoid the risk and
take the $900, although the expected outcome is the same in both
cases. However, if I asked you to choose between losing $900 and take
a 90% chance of losing $1000, it is more likely that would probably
prefer the second option (with the 90% chance of losing $1000) and
thus engage in the risk-seeking behavior in the hope to avoid the loss.
The loss aversion bias is evident in other real-world examples.
 Health The website Stickk allows people to publicly commit to a
positive behavior change (e.g. give up junk food). The goal-setting
platform created by behavioral economists at Yale University and
draws on the principle of loss aversion. For example, if a user
wants to lose weight, the decision to not go to the gym may be
coupled with the fear of loss—a cash penalty in the case of non-
compliance.
Relevant TDL Insights
At TDL we are harnessing our knowledge on the loss aversion bias by
studying and implementing interventions  for social good.

Research on loss aversion is reducing plastic bags in the environment

Homonoff (2017) tested the theory of loss-aversion by assessing

whether charging a tax of $0.05 (penalty) had a bigger impact on
plastic bag reduction than  offering a bonus (reward) of the same
amount . Her results show that plastic bag used declined by 42% after
the tax was implemented but did not change in the bonus treatment –
evidence consistent with a model of loss aversion.

Loss Aversion and Carbon Pricing

Research at TDL on consumer responses and attitudes towards

carbon pricing policies studied the role of loss aversion in a framing
experiment focused on carbon pricing policy. We found that.framing
consumer tax reimbursements as an incentive (reward)  rather than a
dividend or rebate (loss recuperation) increased the positive feeling
towards the policy and intentions to spend the amount on green
renovations.
Interventions
The United Kingdom’s Financial Conduct Authority (FCA) implemented
a behavioral intervention aimed at increasing the amount of options
people consider before choosing a retirement plan. Information was
provided alongside a pension annuity quote which contained
messages taking advantage of loss aversion.

In another intervention, the FCA found that loss aversion framing

combined with using pre-filled switching forms and aptly-timed digital
reminders led to the greatest increase in customers switching savings
accounts.