Loss Aversion Preference

A Loss Aversion Preference is a cognitive bias that prefers loss avoidance to gain acquisition.

• Context:
  • It can lead to Irrational Decision-Making, as people tend to avoid losses even when taking a risk would result in greater overall benefit.
  • It can result in Risk Taking, as individuals may take greater risks to avoid losses than they would to achieve gains.
  • It can lead to a Sunk Cost Fallacy, where individuals continue investing in a losing proposition to avoid feeling the loss.
  • It is a key factor in Prospect Theory (explaining why people value avoiding losses over obtaining gains of the same magnitude).
  • ...
• Example(s):
  • when deciding to quit a long-term project, despite clear indicators that it would result in losses.
  • Investors holding on to losing stocks, hoping they will bounce back, rather than cutting their losses.
  • Employees unwilling to leave a job they dislike because of fear of losing financial stability, even if a new opportunity offers better long-term prospects.
  • Consumers choosing not to switch phone or internet providers, even when switching could save them money, due to fear of losing their current service.
  • Shoppers making purchases during a "limited-time offer" because of fear of missing out, even when they do not need the product.
  • Athletes refusing to switch strategies mid-game despite poor results, because they feel the invested effort would be wasted if they changed course.
  • Homeowners not selling a house for a loss, even if holding onto it incurs higher costs over time.
  • Politicians avoiding policy reversals, fearing public criticism for admitting mistakes, even when the reversal would be beneficial.
  • Students sticking with a major they dislike in college because they feel they have invested too much time to switch to a new field of study.
  • ...
• Counter-Example(s):
  • Gain Aversion, where individuals are more focused on acquiring gains than avoiding losses.
  • Loss Seeking, a rare scenario where individuals take actions to experience loss for perceived future benefits (e.g., tax loss harvesting).
• See: Behavioral Finance, Decision Theory, Windfall Gain, Endowment Effect, Framing Effect, Risk Aversion, Behavioral Economics.

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References

2023

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  • Loss aversion is a cognitive bias that describes the human tendency to feel losses more strongly than gains of equal magnitude, and therefore prefer avoiding losses over acquiring gains.
  • Other terms for loss aversion: “losses loom larger than gains", “negativity bias"
  • Characteristics of loss aversion:
    • It can lead to irrational decision making.
    • It can cause people to stick with the status quo instead of pursuing potentially better options.
    • It can result in risk aversion.
    • It can lead to the sunk cost fallacy.
    • It can be influenced by the framing effect.
  • Related terms: endowment effect, status quo bias, sunk cost fallacy, framing effect

2015

• (Wikipedia, 2015) ⇒ http://en.wikipedia.org/wiki/loss_aversion Retrieved:2015-7-6.
  • In economics and decision theory, loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains. Most studies suggest that losses are twice as powerful, psychologically, as gains. Loss aversion was first demonstrated by Amos Tversky and Daniel Kahneman. This leads to risk aversion when people evaluate an outcome comprising similar gains and losses; since people prefer avoiding losses to making gains. Loss aversion may also explain sunk cost effects. Loss aversion implies that one who loses $100 will lose more satisfaction than another person will gain satisfaction from a $100 windfall. In marketing, the use of trial periods and rebates tries to take advantage of the buyer's tendency to value the good more after the buyer incorporates it in the status quo. Note that whether a transaction is framed as a loss or as a gain is very important to this calculation: would you rather get a $5 discount, or avoid a $5 surcharge? The same change in price framed differently has a significant effect on consumer behavior. Though traditional economists consider this “endowment effect” and all other effects of loss aversion to be completely irrational, that is why it is so important to the fields of marketing and behavioral finance. The effect of loss aversion in a marketing setting was demonstrated in a study of consumer reaction to price changes to insurance policies. The study found price increases had twice the effect on customer switching, compared to price decreases.

2005

• (Novemsky & Kahneman, 2005) ⇒ Nathan Novemsky, and Daniel Kahneman. (2005). “The Boundaries of Loss Aversion.” Journal of Marketing research 42, no. 2
  • ABSTRACT: In this article, the authors propose some psychological principles to describe the boundaries of loss aversion. A key idea is that exchange goods that are given up “as intended” do not exhibit loss aversion. For example, the authors propose that money given up in purchases is not generally subject to loss aversion. The results of several experiments provide preliminary support for the hypotheses. The authors find that, consistent with prospect theory, loss aversion provides a complete account of risk aversion for risks with equal probability to win or lose. The authors propose boundaries for this result and suggest further tests of the model.

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