Definition

Loss aversion is the term used to describe the phenomenon of people's natural tendency to avoid losses. The psychological feeling caused by a certain amount of loss is, on average, twice as strong as the feeling of gain. We display this behaviour when we make choices that include both the possibility of a loss or gain. To put it simply, losing something has a stronger emotional impact than gaining something of the same value. The more one experiences loss, the more likely they are to become risk-averse.

Explanation

"The happiness brought by the RM100 gain is not equivalent to the pain caused by the loss of RM100”. One of the most important and useful findings of prospect theory is the asymmetry in our decisions about gains and losses. In this regard, even Paul Samuelson, a staunch defender of traditional economics, has to admit: "The utility of increasing income by RM100 is less than the utility of losing RM100.”

This is actually the third principle of prospect theory, namely "loss aversion": most people are not sensitive to loss and gain asymmetrically. There is this one experiment conducted by Daniel Kahneman which reaffirmed this claim of human bias towards losses. Suppose there is this gambling game, tossing a fair coin. If the coin comes up tails, you will lose RM100 and if it comes up heads, you will win RM100. Would you take this bet?

The probability of winning or losing this game is the same, that is to say, the expected value of the outcome of this game is zero, which is an absolutely fair game. The result of the experiment showed that on average most people are reluctant to play this game. Why do people make such choices? This phenomenon can also be explained by the loss aversion effect

Although the probability of winning and losing is the same, people are more sensitive to "loss" than "gain". The thought of losing RM100 is more uncomfortable than the thought of the possibility of winning RM100. Because people are much more sensitive to losses than to gains of the same amount, people often dumped stock when they suffer from daily losses despite that fluctuation is a norm in the market. The average person thus would always miss out on investments that could have been profitable, caused by the loss aversion effect.

The diagram above illustrates several core points of prospect theory:

1. Loss aversion: The pain level of a loss of 100 yuan is much greater than the pleasure of a gain of 100 yuan.
2. Diminishing marginal effect: the same 100 yuan income, from 100 yuan to 200 yuan is much more pleasant than from 500 yuan to 600 yuan. The level of pain from loss also diminishes marginally.
3. Reference dependence: People's reaction to a loss or gain of 100 yuan has nothing to do with the absolute value of 100 yuan, but is related to a reference value in your mind. It depends on whether 100 yuan is a lot of money for you or not. The origin in the graph is your reference value

Real Life Example

Following are some of the examples of how loss aversion dominates your life:·

• Unwillingness to change your job even though there are various dissatisfactions in the workplace.
• Unwillingness to let go even if there is dissatisfaction with a lover who has been together for a long time.
• People are more likely to subscribe/purchase a product after free trial as giving up the products would be an emotional loss as they have already incorporated it into their daily routines.
• Discounts work as a huge motivation to buy something. It makes people think of buying now rather than paying much more for the same product later on.

Investment Example

Psychology drives a lot of investment decisions. Following are some of the irrational decisions caused by loss aversion:

• Selling stock in profit without considering the upside potential
• The unwillingness to sell your house at price lower than what you paid for it
• Hold on losing stock infinitely hoping that it could bounce back
• An individual is less likely to buy a stock if it’s seen as risky with the potential for a loss of money, even though the reward potential is high

How to Minimize Loss Aversion

In fact, we all know that the correct way is to stop the loss in time and stop when the situation is deteriorating, or there is no way to reverse the bad situation. However, due to the psychological influence of "loss aversion", many people find it difficult to make a decisive decision, thus falling into a vicious circle of psychological conflict. So, how can we fundamentally overcome this mentality and break the "loss aversion" situation?

1. Fear of failure is real failure. Recognize the so-called losses or failures, and accept them peacefully. Know that an unsatisfactory outcome is a norm in life. Be brave to face loss and take responsibility. On the basis of the existing losses, we could have imagined what the greater losses may be if we do not cut losses. For example, if I don’t throw away the stale food, I may get food poisoning.
2. Lower your expectation: Do not assume a gain in the first place. If a gain is assumed from the beginning, people will unconsciously believe that I should get this profit. If the profit does not reach your expectation, then it will lead to a cognitive gap, and further trigger the illusion of “loss-making”, which leads to the psychological pain of “loss aversion”.
3. Prepare for the worst. Plan for follow-up strategies based on the worst-case scenario. From the “worst case” to the “not so worst case”, people’s psychology will perceive it as “gain” rather than “loss”, which can partially alleviate the pain caused by the loss.

Effect of loss aversion on investing behaviour

People are unwilling to take losses but they’re willing to take risks to avoid losses. Loss aversion can cause investors to take excessive risks in hopes to break even rather than deal with the psychological pain of realizing a loss in their portfolio even when selling is the rational decision. This is similar to gamblers’ behaviour in casinos wherein they would tend to double their bet to cover their previous losses. If the bet goes sideways, their losses get multiplied, causing bigger psychological pain.

Conversely, loss aversion can lead clients to avoid equity markets which could be detrimental for investors with high risk appetite. Investors tend to weigh bad news higher against good news in the equity market, causing them to miss the bull market. Their overconservertism resulting from risk aversion delivers lower returns than expected. Early profit booking and holding on to losers are also some of the investment decisions that go against their way to achieve their financial goals. In fact, Loss aversion is a major reason why so many investors underperform the market

The bottom Line

As the quote by Daniel Kahneman goes: “Money doesn't buy you happiness but lack of money certainly buys you misery.” Loss Aversion is a human nature, existing to keep us from incurring losses rather than achieving similar gains. It cannot be eliminated but investors can be aware of it to avoid getting pushed away from rationality. Only by first realizing that you have fallen into the trap of "loss aversion", and then subconsciously adjusting your cognition, then the corresponding “crocodile effect” applied: in the case of a crocodile bites your foot, stops your losses in time and survives with a broken leg.

Author

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This article is written by Dyce Lim, Research Analyst

Dyce is a research analyst in TED Optimus, tasked with researching and performing analysis on companies. She holds a Bachelor of Science in Financial Analysis Degree from Sunway University. During her time at Sunway University, She has participated in the CFA Research Challenge 2019/2020 and won second runner-up in the event. She is also a CFA Level 2 candidate. She is an in-house author of TED Optimus.