Loss Aversion

. In decision-making, we face options, ie risk of loss and opportunity of gain. Your answer to the following question will indicate your risk aversion.

Q. You are offered a gamble on the toss of a coin.

- if the coin shows tails, you lose $100

- if the coin shows heads, you win $150

Is the gamble attractive? Would you accept it?

The response:

Need to balance the choice between the chance of gaining $150 against the chance of losing $100, ie you stand to gain more than you could lose.

If the fear of losing $100 is more intense than the chance of gaining $150, then you are risk averse, ie losses loom larger than gains.

Generally, if the potential gain is increased to $200, almost all accept the gamble, ie it is the smallest gain to balance the chance of losing $100. If asked to think like a trader, people become less loss averse and their emotional reaction to loss is less.

. Some more examples on the subjective impact of possible losses and offsetting gains:

- Consider a 50-50 gamble in which you can lose $10. What is the smallest gain that makes the gamble attractive?

- What about the possible loss of $500 on a coin toss? What possible gain the required to offset it?

- What about the loss of $2,000?

The response:

- if you say $10, you are indifferent to risk; if your answer is above $10, you are loss averse; if your answer is less than $10, you seek risk

- your loss aversion tends to increase when stakes rise but not dramatically unless it is potentially ruinous and/or your lifestyle is threatened

. In mixed situations, where both gain and loss are possible, loss aversion causes extreme risk aversion choices. In bad choices, where a sure loss is compared with a large loss that is merely probable, diminishing sensitivity causes risk taking

. People are more worried about fear of losing something then the reward of possible gains. For example, for investors the fear of losing money is much stronger than any hope for gain. So when a market goes into one of its normal temporary declines, the fear instinct can dominate and it can result in mass selling which will exaggerate the decline. Also, people are most likely to react negatively if the loss is going to be in the short term while the gain in the long term.

. People are guided more by the immediate emotional impact of gains and losses, not by long-term prospects of wealth and global utility

"...people evaluate many outcomes as gains and losses and that losses loom larger than gains......a biological and psychological view in which negativity and escape dominate positivity and approach..."

Daniel Kahneman 2012

"...the negative trump the positive in many ways, and loss aversion is one of the many manifestations of broad negativity dominance......bad information is processed more thoroughly than good. The self is more motivated to avoid bad self-definitions into good ones. Bad impressions and bad stereotypes are quicker to form a than good ones..."

Paul Rozin as quoted by Daniel Kahneman 2012

. It is widely accepted that stable relationships require good interactions to outnumber bad interactions by 5 to 1

. Loss aversion favours stability over change. The instability of preferences produces a preference for stability.

"...In addition to favouring stability over change, the combination of adaptation and loss aversion provides limited protection against regret and envy reducing the attractiveness of foregone alternatives and of others' endowments..."

Daniel Kahneman 2012


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